The Federal Reserve’s decision on Wednesday to hold rates steady amid rising uncertainty strongly implies that the central bank’s forecasters are pointing to the impact of a trade shock that has already started and is going to get turbocharged with new tariffs on April 2.
It is a stagflation-lite forecast, and the two rate cuts implied by the “dot plot” look suspiciously unlikely.
While the Fed in the coming days will attempt to play down this dynamic, it will not be able to avoid a policy dilemma that will put pressure on both sides of its mandate: price stability and maximum sustainable employment.
When taken together, the tone and tenor of the Federal Open Market Committee’s policy statement, Summary of Economic Projections, rate forecast and Fed Chair Jerome Powell’s remarks are that of a central bank that is on its heels and looking to ascertain the difference between signal and noise as it determines its policy.
The Fed will be on hold for much of the year. If rate cuts come, they will be because there are real cracks in the labor market and growth is decelerating at a much faster pace than the Fed projects.
The key takeaway in the policy statement is “uncertainty around the economic outlook has increased” while the committee removed language saying that risks to achieving employment and inflation goals are “roughly in balance.”
It is a stagflation-lite forecast, and the two rate cuts implied by the “dot plot” look suspiciously unlikely at this point. If anything, the policy statement reads as hawkish even though the Fed held its policy rate in a range between 4.25% and 4.5%.
Read more of RSM’s insights on the economy and the middle market.
Given the likelihood that the United States will impose significantly higher tariffs over the next month, there is a strong probability that the forecasts just published will be somewhat out of date when the Fed next meets in May.
It is rational for policymakers and investors to assume that the risk to growth is to the downside and that the probability of higher inflation and unemployment this year may be likelier than indicated in the current forecast.
While we are holding to our forecast of two rate cuts this year, they will require real cracks in the labor market before the Fed would move to risk price stability in an environment where prices are going to increase.
Summary of Economic Projections
The Fed revised down its growth forecast for this year to 1.7% from 2.1%, revised up its forecast of unemployment to 4.4% from 4.3%, its PCE inflation forecast to 2.7% from 2.5% and its core PCE estimate to 2.8% from 2.5%.
We have made the case recently that a slower pace of growth, sticky service inflation and the current trade shock are creating the conditions for stagnation at best and stagflation-lite at worst.
That fewer policymakers in the most recent rate projections favor two quarter-point rate cuts this year is indicative of the risks to both sides of the mandate in general and the price stability policy objective in particular.
We maintain that if a choice between price stability and maximum sustainable employment is put to central bankers within the context of a stagflation like environment, those policymakers will more often choose rate hikes.
The fact that the Fed chose to slow the pace of the runoff in its balance sheet of Treasury securities from $25 billion to $5 billion per month, while maintaining the monthly redemption cap on agency debt and agency mortgage-backed securities at $35 billion is indicative of the risks around the economic and financial outlook.
To a certain extent, the reduced pace of the runoff is necessary given challenges around the debt ceiling. We do not think that the Fed will restart its runoff of Treasury securities above those levels, and we think that the next step will be to end them.
Powell’s news conference
The first and most appropriate question for Powell in his news conference was on inflation expectations. Powell emphasized the importance of inflation expectations, and he noted that our preferred metric for long-run inflation expectations, the Fed’s five-year/five-year forward breakeven has been steady, it is clear that policymakers at the most senior levels are concerned about rising expectations of inflation.
Perhaps just as important, Powell noted that inflation is rising in part because of tariffs. He called it “tariff inflation,” so his remarks reaffirmed the stagflation-lite nature of the Summary of Economic Projections and the modest changes to the rate forecast.
One of the surprises is that Powell noted that “transitory” is the base case. Given the controversy around Powell’s use of that term when inflation began its ascent several years ago, the Fed is opening itself up to criticism. Still, that is the word of the day even as the risks implied by the Fed’s own forecast are clear.
The takeaway
The trade shock will accelerate next month. It will be a number of months before the Federal Reserve will be able to ascertain its impact on growth, employment and inflation. For this reason, rate cuts, if they come at all, figure to be a late second-half phenomenon.
The Fed’s forecast implied mild stagflation ahead in the near term as growth slows and inflation increases. Given the pervasive uncertainty around the size and magnitude of the trade shock, the Fed’s wait-and-see approach will prove challenging at best.
The primary takeaway for businesses, policymakers and investors from the Fed’s decision is risk aversion until the size of the shock can be ascertained and the new rules of the road for trade and finance are set.
