By Howard Schneider, Ann Saphir

WASHINGTON (Reuters) -The U.S. central bank lowered interest rates on Wednesday, but Federal Reserve Chair Jerome Powell said more reductions in borrowing costs hinge on further progress in lowering stubbornly high inflation, remarks that showed policymakers are beginning to reckon with the prospects for sweeping economic change under an incoming Trump administration.

Powell’s explicit – and repeated – references to the need for caution from here jolted Wall Street, sending stocks sharply lower and spurring a dialing back of market estimates of how far borrowing costs are likely to fall over the coming year.

“I think we’re in a good place, but I think from here it’s a new phase and we’re going to be cautious about further cuts,” Powell said at a press conference following the end of the Fed’s latest two-day policy meeting.

The Fed and Powell had been widely expected to deliver a “hawkish” rate cut by estimating roughly half the policy easing in 2025 than the 100 basis points policymakers had projected three months ago. But by the time Powell had finished speaking, only one 25-basis-point cut for next year was reflected in market pricing.

As expected, the Fed lowered its policy rate by a quarter of a percentage point to the 4.25%-4.50% range, a decision Powell described as a “closer call,” noting that the slower pace of projected rate cuts next year reflected higher inflation readings in 2024.

Indeed, the decision to cut rates drew a dissent from Cleveland Fed President Beth Hammack, who joined the central bank earlier this year and indicated she would have preferred to leave rates unchanged at this week’s meeting.

“Economic activity has continued to expand at a solid pace” with an unemployment rate that “remains low” and inflation that “remains somewhat elevated,” the central bank’s rate-setting Federal Open Market Committee said in its latest policy statement.

“In considering the extent and timing of additional adjustments to the target range … the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks,” it said in new language that sets up a likely pause to rate cuts beginning at the Jan. 28-29 meeting.

U.S. central bankers now project they will make just two quarter-percentage-point rate reductions by the end of 2025.

That is half a percentage point less in policy easing next year than officials anticipated as of September, with Fed projections of inflation for the first year of the new Trump administration jumping from 2.1% in their prior projections to 2.5% in the current ones – well above the central bank’s 2% target.

Slower progress on inflation, which is not seen returning to the 2% target until 2027, translates into a slower pace of rate cuts and a slightly higher ending point of 3.1%, also hit in 2027, versus the prior “terminal” rate of 2.9% seen as of September.

Fed officials also boosted their estimate of the long-run neutral rate of interest to 3%.   

“While the Fed opted to round out the year with a third consecutive cut, its New Year’s resolution appears to be for a more gradual pace of easing,” said Whitney Watson, global co-head and co-chief investment officer of fixed income and liquidity solutions for Goldman Sachs Asset Management. Watson added that “we expect the Fed to opt to skip a January rate cut, before resuming its easing cycle in March.”

TRUMP UNCERTAINTY

The new policy rate is now a percentage point lower than the peak reached in September when officials concluded inflation was likely on the way back to the 2% target and that there were risks to the job market of keeping monetary policy too tight for too long.

Key measures of inflation since then, however, have largely moved sideways, while continued low unemployment and stronger-than-expected economic growth have sparked debate among policymakers about whether monetary policy is as tight as thought – a discussion reflected in the steady increase in the long-run estimate of the neutral rate over the past year from 2.5% to 3.0%.

The Fed, which hiked rates aggressively in 2022 and 2023 to combat a surge in inflation, began its easing cycle in September with a half-percentage-point cut in borrowing costs. It lowered rates by a quarter of a percentage point last month.

The latest quarterly projections are the first since President-elect Donald Trump’s victory in the Nov. 5 election, which introduced a new level of uncertainty into the economic outlook given his campaign promises for tax cuts, tariff hikes, and a crackdown on unauthorized immigration – aspects of which some analysts see as inflationary.

Trump doesn’t take office until Jan. 20, and Fed officials have said they can’t base monetary policy on campaign proposals that may or may not be enacted. Still, Powell said some policymakers took into account “highly conditional estimates” of effects from the incoming administration’s anticipated policies.

Fed staff have likely been gaming out different scenarios, and policymakers’ projections show growth remaining above potential at 2.1% next year, inflation staying above target for two more years, and the jobless rate never rising above 4.3%.

(Reporting by Howard Schneider and Michael S. Derby; Editing by Paul Simao)

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