The Fed's December Policy Dilemma: Navigating a "Hawkish" Rate Cut in a Divided Economic Climate

The Federal Reserve faces a pivotal decision in December 2025, as it attempts to balance the dual mandates of price stability and maximum employment amid a fractured economic landscape. With the probability of a rate cut dropping sharply from 97% to 41%, the central bank must navigate conflicting signals: a resilient labor market with rising unemployment, inflation stubbornly above target, and growing concerns about the drag from tariffs and policy uncertainty. This dilemma underscores the Fed's challenge in maintaining central bank credibility while signaling a path that avoids market volatility.

A "Hawkish" Rate Cut: Balancing Credibility and Flexibility

The concept of a "hawkish rate cut" may seem paradoxical, but it reflects the Fed's delicate balancing act. A 0.25% reduction in the federal funds rate-bringing the target range to 3.5%–3.75%-could be framed as a measured response to transitory inflationary pressures from tariffs rather than a shift toward aggressive easing. This approach aims to preserve the Fed's credibility as an inflation-fighter while acknowledging the need to support a slowing economy.

Julius Baer's analysis highlights this tension, noting that the Fed's credibility hinges on its ability to distinguish between temporary disruptions (e.g., tariff-driven inflation) and structural trends. By emphasizing the transitory nature of current inflation, the Fed can justify a rate cut without undermining its long-term commitment to price stability. However, this strategy risks confusion if market participants interpret the move as a signal of prolonged accommodative policy, particularly given the shrinking USD yield advantage and the dollar's potential downward trend.

Central Bank Credibility in a Dovish World

The Fed's December decision must also be viewed through the lens of global central bank divergence. While the ECB is expected to adopt a dovish stance in 2025 due to deflationary pressures in the eurozone, the Fed's hawkish posture-prioritizing inflation control over growth-could strain its credibility if economic conditions deteriorate further. Julius Baer warns that political uncertainties add layers of complexity to the Fed's calculus. A delayed or conditional rate cut may be necessary to align with its inflation mandate while avoiding premature concessions to political or market pressures.

Market Signaling and Policy Uncertainty

The Fed's communication strategy will be critical in shaping market expectations. Despite mixed economic data, the central bank's Summary of Economic Projections (SEP), to be updated at the December meeting, will serve as a key signal for 2026 and beyond. However, internal divisions among policymakers-such as Kansas City Fed President Jeffrey Schmid's dissent against rate cuts-highlight the lack of consensus. This uncertainty could amplify market volatility, particularly as financial institutions recalibrate strategies for an extended period of cautious easing.

Investors must also contend with the Fed's dual challenge: signaling sufficient support for growth without eroding inflation-fighting credibility. A "hawkish rate cut" could achieve this by anchoring expectations to a gradual, data-dependent path, but only if the Fed's messaging remains consistent.

Implications for Investors: Diversification in a Divided Climate

Julius Baer's investment strategy emphasizes diversification beyond the U.S., recommending exposure to markets in Europe, Japan, China, and India, as well as assets like gold and global equities. This approach reflects the firm's view that the Fed's policy trajectory, combined with global economic divergence, will create opportunities in undervalued regions and asset classes. For instance, the ECB's dovish turn and the SNB's rate-cutting path could drive capital flows to European equities and emerging markets, while the Fed's cautious stance may limit U.S. equity outperformance.

Conclusion

The Fed's December decision will test its ability to navigate a "hawkish rate cut" in a divided economic climate. By framing the cut as a response to transitory factors and maintaining a firm inflation mandate, the central bank can preserve credibility while providing targeted support. However, the path forward remains fraught with uncertainty, requiring investors to adopt a diversified, forward-looking strategy. As the Fed's December meeting approaches, markets will scrutinize both the size of the rate cut and the clarity of its messaging-two elements that will shape the trajectory of global financial markets in 2026.