Major investment banks have significantly revised their Federal Reserve policy expectations, with JPMorgan now forecasting the central bank's next move will be a rate hike rather than a cut, while other major institutions have postponed their rate reduction timelines following mixed December employment data.

JPMorgan Shifts to Rate Hike Forecast

JPMorgan has withdrawn its outlook for a January rate cut and now predicts the Fed's next move will be a 25-basis-point rate hike in the third quarter of 2027. The bank cited expectations that the labor market will tighten by the second quarter and that the disinflation process will be gradual. Macquarie has reiterated its forecast of a rate hike in the December 2026 quarter, aligning with the more hawkish outlook.

Banks Postpone Rate Cut Expectations

Several major financial institutions have pushed back their rate cut forecasts following the December employment data:

Goldman Sachs noted that if the labor market stabilizes as expected, the Federal Open Market Committee will likely shift from risk management mode to normalization mode. The bank has also lowered its 12-month U.S. recession probability to 20% from 30%.

December Employment Data Influences Market Expectations

Data released on Friday showed U.S. employment growth slowed more than expected in December. However, the unemployment rate declined to 4.4% and wage growth remained solid, suggesting the labor market was not rapidly deteriorating. These mixed signals have boosted expectations that the central bank will leave borrowing costs unchanged at its January meeting.

Traders are now betting on a 95% chance for the Fed to keep rates unchanged at its January meeting, according to the CME FedWatch tool, representing an increase from 86% before the employment data release.

Political Tensions Over Fed Independence

Tensions between President Trump and Fed Chair Jerome Powell have intensified over central bank independence. Powell stated on Sunday that the Trump administration had threatened him with a criminal indictment, raising concerns about political pressure on monetary policy decisions. Powell characterized this as a "pretext" to gain more influence over interest rates that Trump wants cut dramatically.

Market Outlook and Analysis

JPMorgan noted that if the labor market weakens in the coming months or if inflation falls materially, the Fed could still ease rates later in the year. However, the bank expects labor market conditions to tighten and disinflation to proceed gradually. BofA Global Research maintained that the mix of data is consistent with their view that breakeven job growth might be falling due to labor supply shocks even faster than the Fed will acknowledge.

American labour productivity demonstrated remarkable strength in the third quarter of 2024, with non-farm employee output per hour increasing at a 4.9% annualized rate, according to Bureau of Labor Statistics data. This performance marked the strongest productivity growth since 2023 and represented the second-strongest reading in two decades when excluding bounce-back quarters around recessions.

Declining Labour Costs Support Economic Efficiency

The productivity gains were accompanied by significant cost reductions, as unit labour costs declined for the second consecutive quarter. The data reveals a notable pattern of cost containment across recent quarters.

These developments create favourable conditions for continued inflation moderation while supporting economic growth and record stock market performance. The combination of rising efficiency and lower costs represents a positive economic dynamic that has been developing over three years.

AI Adoption Drives Business Transformation

Artificial intelligence adoption appears to be a significant factor behind the productivity surge. Census Bureau Business Trends and Outlook Survey data shows substantial growth in AI implementation across American businesses.

The survey methodology evolved during this period, with questions expanding from AI use in "production of goods and services" to "any business function," which may partially explain the dramatic increase in reported usage.

Productivity Impact Varies by Industry and Skill Level

Research studies demonstrate varying AI effectiveness across different sectors and worker skill levels. Marketing research by Harang Ju and Sinan Aral found human-AI teams achieved 73% higher productivity compared to all-human teams. In software development, developers using AI tools completed 26% more tasks than their counterparts without such assistance.

However, traditional industries show more modest gains. Taxi drivers using AI customer-finding tools experienced only 7% productivity improvements for low-skilled drivers, while high-performing drivers saw virtually no benefit. This suggests AI's effectiveness depends heavily on industry context and existing worker capabilities.

Monetary Policy Implications Remain Complex

The productivity gains present mixed signals for Federal Reserve policy considerations. While lower unit labour costs support disinflationary trends, higher productivity typically increases investment capital demand and potential GDP growth rates, potentially raising the neutral interest rate.

Federal Reserve rate adjustments have progressed significantly, with benchmark rates declining 75 basis points from the 4.25%-4.5% range in September to the current 3.5%-3.75% level. However, Federal Reserve Bank of New York data shows consumer inflation expectations rising to 3.42% for the next 12 months, up from 3.20% in November and moving further from the central bank's 2% target.

The productivity revolution's sustainability and broader economic implications remain uncertain, suggesting a cautious approach to monetary policy adjustments as additional data on productivity, inflation, and labour market conditions becomes available.