Pimco: Fed pauses as rate recalibration continues

The US Federal Reserve kept its key rate unchanged at 3.75%–4.0% at its October meeting, pausing after raising 25 basis points (bps) in September, while maintaining a clear restrictive stance. We expect a further 25 basis point hike in December and believe another hike is possible in early 2027, followed by a prolonged period of unchanged rates. In our view, this is still a recalibration of monetary policy, rather than the start of a prolonged cycle of rate hikes.

Before Chairman Kevin Warsh's press conference, the central question was why the Fed should wait to raise rates again given that growth remains strong and inflation remains high. Warsh's explanation was that policymakers want more time to evaluate how September's rally and tightening financial conditions are affecting the economy. The majority of committee members, Warsh implied, believe that "the medicine is starting to work."

A pause to evaluate the effects of the tightening already underway

The case for keeping rates unchanged was partly based on financial conditions. Throughout 2026, longer-dated U.S. Treasury yields rose significantly, pushing up borrowing costs and partially offsetting growth support from strength in equity markets. Furthermore, credit spreads have recently widened for lower credit quality issuers (primarily those with CCC ratings) and for some components of the AI ​​value chain, whose business models are particularly highly dependent on substantial upfront investments and uncertain levels of ongoing maintenance investments.

This is in line with Warsh's argument that technology investments are sensitive to interest rates and gives policymakers leeway to wait and evaluate the effects of higher rates, rather than intervene in consecutive meetings.

However, a pause does not mean that the Fed has finished the process of adjusting monetary policy. Domestic spending continues to show good resilience, capital investments remain strong and inflation has recorded a sideways trend. These conditions lead policymakers to keep their guard up to prevent inflation from remaining above the target, both because demand remains stronger than expected and because new shocks on the supply side could further fuel price pressures.

The statement states that "acquisition of further information" will help determine the monetary policy stance needed to ensure a timely return of inflation to 2%. We interpret this wording as a way to maintain flexibility on the timing and extent of further monetary policy tightening, rather than as a signal that September's hike was sufficient.

The committee vote also highlights a debate over the pace of monetary tightening. The October decision was approved with 10 votes in favor and 2 against: Fed governor Lisa Cook and the president of the Federal Reserve Bank of Cleveland, Beth Hammack, would have preferred a further increase of 25 basis points. The president of the Federal Reserve Bank of Dallas, Lorie Logan, and the president of the Federal Reserve Bank of Minneapolis, Neel Kashkari, who had expressed dissent in favor of an increase in July, instead supported keeping rates unchanged in October.

Their support is consistent with the desire to proceed gradually and aligns with the positions expressed by numerous Fed policymakers, who, both in recent statements and in the minutes of the September meeting, continued to frame further tightening as a risk management measure, to be evaluated in the event that demand proves to be stronger than expected or inflationary pressures on the supply side re-emerge.

Importantly, Warsh did not endorse the view that the economy is clearly overheating. He indicated that, in the opinion of most of his colleagues, the economy is not growing at an excessively fast pace, also underlining that inflation expectations have remained stable.

A recalibration, not a prolonged cycle of rate hikes

Warsh also outlined some changes to the Fed's meeting calendar. The central bank will continue to meet eight times a year, but starting in the fall of 2027, one meeting will be dedicated to monetary policy strategy, rather than a vote on monetary policy decisions. In 2028, this structure will move to six meetings dedicated to monetary policy decisions and two meetings dedicated to strategy, with no votes on monetary policy decisions. It has not yet been determined which meeting will be the first to adopt the new strategic format.

This distinction reserves more space specifically dedicated to strategic comparison, but does not in itself indicate a different end point for interest rates. As we argued after the September meeting, the Fed's adjustment of monetary policy could represent something more than a precautionary measure against the risk of an unfavorable outcome on the inflation front. It also reflects dissatisfaction with the slow pace with which inflation is returning to target. The October break does not change this underlying motivation.

However, the current situation is different from that of 2022. The moderation of wage growth and unit labor costs, together with the solidity of productivity, justifies a more gradual response than what would be necessary in a phase of generalized overheating of the economy, driven by the labor market.

Our base case continues to see a rate hike in December, with the risk of a further increase in early 2027, before an extended pause. Importantly, the rise in longer-dated yields was largely driven by higher policy rate expectations, rather than by rising term premiums. In the next meetings, the maintenance of this tightening will depend on the Fed's ability to implement the increases already priced in by the markets; otherwise, financial conditions could ease, helping to keep inflation high.

As 2027 approaches, however, clearer signs of disinflation and a stronger dampening impact of higher financing costs could reduce the need for further rate hikes. The medicine may have started to take effect, but the Fed has not yet declared the treatment complete.