The Federal Reserve left interest rates unchanged yesterday, as expected, but the challenges are increasing for identifying the right monetary policy for the path ahead.

It’s tempting to think otherwise after reading the Fed statement issued on Wednesday: “Available indicators suggest that economic activity has been expanding at a solid pace. Job gains have remained low, and the unemployment rate has shown some signs of stabilization. Inflation remains somewhat elevated.”

Hardly ideal, but good enough to leave the Fed’s target rate steady at a 3.5%-to-3.75% and argue that the central bank’s policy matches an economy that’s stabilized and growing. But the risks of a policy mistake may be growing. The bad news is that it’s not obvious what type of mistake is lurking as it continues to juggle the threat of inflation against a softer labor market.

For now, the Fed still seems to be betting that the recently stalled moderation of inflation will resume a downward path in the months ahead, paving the way for more rate cuts. Running the latest Fed statement through an AI program (with access to the historical economic data and analysis) suggests a bias for more cuts in the year ahead, per the chart below.
 

The Fed funds futures market is more cautious on the outlook, but sentiment is pricing in a resumption of rate cuts starting in June.

The policy-sensitive US 2-year yield is cautiously on board with a dovish policy path… maybe. This yield, which is widely followed as a proxy for policy expectations, ticked lower again yesterday, dipping to 3.58%, or close to the lower range of the Fed’s target rate.
 

(Click on image to enlarge)

The core of the case for favoring more rate cuts is, as the Fed statement termed it, “low” job gains of late. The tricky part is that while hiring has slowed, layoffs have remained low and “the unemployment rate has shown some signs of stabilization,” the FOMC statement notes. In other words, current conditions leave room for debate about whether a “normal” business-cycle process is playing out that requires rate cuts to offset a downshifting labor market.

The jury’s still out on how to interpret the slowdown in hiring. One line of reasoning is that the labor supply has fallen to the point that the breakeven level for job creation – the number of monthly payrolls jobs required to maintain a stable unemployment rate – has declined. By some accounts, the breakeven jobs level has fallen from 100,000-150,000 new hires a month in the recent past to 30,000 to 60,000 in late-2025.

On that basis, the labor market can slow without raising recession risk, or so the theory goes. A degree of support for this assumption can be found in the relatively stable and low unemployment rate – 4.4% as of December – and a low level of jobless claims, which totaled 200,000 for the week through Jan. 17, which is near the lowest level in four years.

If a softer labor market isn’t a threat to the economy that it appears to be, that opens the door to leave interest rates steady. In turn, inflation can be the main focus for the Fed, but here, too, the outlook is cloudy as economists continue to struggle to explain recent history and use that analysis to project the near-term outlook.

The Fed’s preferred measure of inflation – the PCE price index – suggests that pricing pressure has turned sticky in the upper 2% range, which is moderately above the Fed’s 2% target. The dilemma is that more rate cuts could keep inflation moderately elevated, if not provide more fuel to move the pricing trend higher later in the year.
 

The 10-year Treasury yield appears to be picking up on the potential for inflation risk. The benchmark rate, after bottoming in October at roughly 3.95%, has been gradually trending up, closing yesterday at 4.25%. A similar rise has been unfolding with the 30-year yield, the most inflation-sensitive maturity.
 

(Click on image to enlarge)

Part of the reason why long rates have been edging up isn’t inflation per se. The outlook for economic activity has improved and recession fears have receded. The Atlanta Fed’s GDPNow model is nowcasting that the upcoming (and delayed) fourth-quarter GDP report will show an ongoing acceleration in output. Other nowcasts for Q4 indicate a softer pace of growth, but the common denominator is that the odds that a recession has started, or is imminent, are low if not nil. An early read on the Dallas Fed’s Weekly Economic Index (WEI) also points to comparable growth compared with recent history. An early estimate of economic conditions for January (as of Jan. 17) also point to an ongoing expansion, based the Dallas Fed’s Weekly Economic Index.

The Fed’s challenge is deciding if inflation or a slower labor market is the bigger risk. That’s always a judgment call, but it’s especially challenging these days, and it comes with a particular set of issues since the central bank can’t effectively combat both risks at the same time.

A critical component in the mix is how the bond market interprets the Fed’s policy decisions going forward. Using the 10-year yield as a guide, the crowd appears to be increasingly skeptical that rate cuts are warranted. The benchmark rate’s recent rise could be noise, but if it continues to trend up the macro calculus could change, perhaps dramatically.

A key level to watch: 4.30%. If the 10-year yield breaks above this level, and keeps on running, the Fed may be forced to revise its policy plans.

More By This Author: