• No surprise: quarter point cut, new range 3.5% to 3.75%.
• Likely pause in January.
• Committee median expectation for Fed Funds at end of 2026: 3.375% or one more cut.
• Larger than expected buying of Treasury Bills each month to inject reserves into banking system.
  
   

Positive face 

Today, the Federal Reserve Open Market Committee lowered its overnight Fed Funds range by another quarter point step. Today’s rate cut brings the total reduction in short-term rates to 1.75% since this cycle began. The Committee believes that “uncertainty about the economic outlook remains elevated.”

As at the October meeting, the Committee justified its cut by stating that the unemployment rate “has edged up.” While acknowledging that inflation “remains somewhat elevated,” the Committee apparently is more concerned with the labor market.

Three voters dissented; two wanted no change and one, Stephen Miran, wanted a half of a percent cut. Schmid and Goolsbee, along with other regional Fed bank presidents, have been vocal in their opposition to lowering rates. 

How low?

The banker’s question is, “how low will rates go”? The Committee’s projections, nicknamed the “Dot Plot,” suggest only one cut later next year. The median projection sits at 3.375% for the end of 2026.

In his press briefing, Chairman Powell stated that Fed Funds are now “at the high end of neutral.” Neutral for the Fed means that this rate level is high enough that it unnecessarily slows the economy or so low that it spurs inflation. Powell went on to state that the Fed is “well positioned to wait and see how the economy performs,” which is code for, “we will likely stand pat in January.”

Behind the scenes

The Committee continues to focus on unemployment. A 3% and rising inflation rate, far above the Fed’s 2% goal, has taken a back seat. Financial credit is fairly easy to come by. The Committee acknowledged in its quarterly projection update that GDP growth should be stronger than forecast earlier this year. Prior rate-cutting cycles focused on creating easier credit to spur lending and help the economy.

What other reason would cause the Fed to cut rates and start buying Treasury Bills? The banking system must have a certain level of cash on hand, or reserves. Thanks to tax payments and the government shutdown, reserves were drained from banks into the Treasury. This lack of reserves shows up in the overnight lending markets, where we have seen nightly rates at or above 4% in recent weeks. The Fed will start buying $40 billion of Treasury Bills per month through April tax season. This should help interbank liquidity and lower overnight borrowing costs. Who else likes higher reserves? The stock and bond markets. Both rallied on the news, as the $40 billion was higher than expected. The Dow Industrial index hit.  

Other help?

One justification for lower interest rates is that they will bring down long-term rates. Lower 10-year Treasury rates should help the housing market with lower mortgage rates. That certainly held true in the last four rate-cutting cycles of ’89, ’00, ’07 and ’19. Note that in those cycles the economy was either headed toward or in recession. This cycle, 10-year yields are half a percent higher today than when the Fed began cutting September a year ago.

Continuing inflation pressures, other central banks raising interest rates and possible stimulus from Congress are pressuring rates higher. This cycle will not help mortgage rates. 

Summary

After the October meeting we wrote: “We think the Fed cuts one more time after realizing that the economy is doing better than news reports suggest. That cut could be in early 2026 rather than December.” Well, we were wrong on timing, but right on the economy as the Committee raised its outlook for GDP growth and employment.

The underlying issue around this rate cut and Fed buying is banking liquidity in the form of reserves. Markets and bankers were worried the Fed did not recognize excess reserves falling from “abundant” (~11% of GDP) to “ample” (~8% of GDP). Recall that before 2008, the banking system ran fine on “scarce” reserves of 5% to 7% of GDP, or approximately the amount of currency in circulation.  

Markets want two cuts next year; the Fed is projecting one. We think the Fed stands pat in January and by May may be surprised at the strength of the economy. There is some chatter out there that a 2026 rebound would be cause for a rate hike. We are not ready to go that far yet.

We continue to believe the economy gets a boost in the first quarter of next year from the One Big Beautiful Bill. Consumer spending will hang in basically flat after inflation. Tech and data center spending may moderate slightly but will still be a significant boost to the economy.

Please let us know how we can help you. 

Steve Orr is the Managing Director and Chief Investment Officer for Texas Capital’s Private Bank. Steve has earned the right to use the Chartered Financial Analyst and Chartered Market Technician designations. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary’s University School of Law. Follow him on X here.  

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