The 18 December meeting was supposed to be a “business as usual” FOMC meeting, the last macro event of an otherwise eventful year before investors finally focus on the holiday season. The Fed was expected to seamlessly continue its rate cut cycle, which began in September, while refining its guidance for 2025 in response to stronger recent economic and inflation trends. Instead, it delivered a market-shaking surprise with potentially lasting impacts. The expected 25bp rate cut was the only aspect that unfolded as planned—everything else came as a shock.

Firstly, Fed’s Chair Jerome Powell revealed that the decision for the rate cut this time was “a closer call”, implying that the decision was not a foregone conclusion contrary to what markets had been expecting. Indeed, one of the twelve voting members of the committee officially dissented and voted for maintaining the rate unchanged, and Jerome Powell’s remark suggests that several other members were hesitant in the decision to lower rate this month.

Secondly, the Fed raised its inflation and growth forecasts significantly, signalling that the risks to the outlook had shifted upward. The most spectacular revision was on the inflation side: PCE inflation is now expected to remain above the Fed’s 2% target until 2027. The Fed expects inflation to pick up to 2.5% in 2025 after 2.4% in 2024, and to still be at 2.1% in 2026. This persistence of inflationary pressures stands in stark contrast to September’s projections, when inflation was projected to slow down to 2.1% next year and settle at 2.0% in 2026. In parallel, Fed’s projections now paint a slightly better outlook for growth and employment next year, with projected GDP growth revised up to +2.1% (vs +2.0% in September) and the projected unemployment rate revised lower to 4.3% (vs 4.4% in September).

Fed’s participants raised their median estimate of future rate levels compared to the September meeting

Beyond the technical and uncertain adjustments to interest rate trajectories, the Fed’s message hints at a deeper shift: the US economy may be transitioning from decades of monetary dominance to an era of fiscal dominance, following decades of monetary dominance and a bout of exceptional policies triggered by the Covid pandemic.

With a new administration just weeks away and after years of unprecedented public deficits, fiscal policy still seems to be the main force driving the US economy, even as the pandemic's effects have largely faded.

The proof of this is the remarkable resistance of activity growth in the past two years, when virtually all models and economists predicted that the sharp monetary policy tightening would cause a recession. The 525bp rate hike cycle in 18 months should indeed have caused a recession in the US if fiscal policy remained passive and neutral. Passive and neutral it was not, as the series of fiscal stimulus measures during the Covid pandemic, along with the so-called Inflation Reduction Act of 2022, boosted activity and employment, driving inflationary pressures and more than counteracting the effects of rising interest rates.

While the economic policy response to the shock of the Covid pandemic was both exceptional and warranted due to the emergency of the situation, the fact that fiscal policy support has extended through the past couple of years reveals a shift in attitude toward public deficits. Fiscal policy support is becoming a permanent feature of the US economic policy mix, even as economic conditions have normalised, and no new external shock has hit the economy. The immediate consequences are persistently high public deficits and surging public debt, with a direct upward impact on inflationary pressures and interest rates. The fact that fiscal policy is poised to remain on this course under the next administration likely drove the Fed’s revisions to its growth, inflation, and rate outlook announced this week.