The Fed’s Reaction Function After the Cutting Cycle

The market spends enormous energy forecasting the next rate decision and almost none understanding the function that produces it. A central bank does not set policy off a point forecast; it responds to the balance of risks it most wants to avoid. Model the reaction function — what the committee is actually trying not to do — and the individual meetings largely forecast themselves.

Markets price paths, the Fed prices pain

Rate expectations are a smooth curve of implied moves. The committee's decision process is not smooth; it is asymmetric and loss-averse. Through the 2026 easing cycle the revealed preference has been clear: the Fed will tolerate inflation running modestly above target far longer than it will tolerate a disorderly labor market. That asymmetry is the whole game, and it is not what a symmetric Taylor-rule curve implies.

The asymmetry of the 2026 cuts

Each cut this cycle has been justified less by inflation returning to target than by the committee's unwillingness to be seen as the cause of rising unemployment. That tells us the bar to pause is high and the bar to re-accelerate cuts on labor weakness is low. The distribution of outcomes is skewed toward easier policy on any growth scare and sticky policy on any inflation surprise — a reaction function that is dovish on employment and permissive on prices.

The committee will tolerate inflation it can explain long before it tolerates unemployment it caused.

Where the curve is mispriced

If the reaction function is asymmetric, a symmetric curve must be wrong somewhere. We think the front end underprices the committee's willingness to cut into a growth wobble, while the belly underprices the inflation persistence that permissiveness invites. That argues for curve steepeners expressed with defined risk, and for owning breakeven inflation cheaply against a committee that has told us, through its actions, that it will let prices run.

The trade is the function, not the meeting

We do not position for a single decision. We position for the shape of the distribution the reaction function creates, and we let the meetings resolve into it. When the market prices the Fed as a symmetric rule and the Fed behaves as an asymmetric loss-minimizer, the gap between the two is the opportunity.