As expected, the Federal Open Market Committee held its policy rate within a range of 3.5% to 3.75% on Wednesday.
The Federal Reserve’s wait-and-see stance reflects uncertainty regarding the impact of tariffs on inflation and what appears to be a weakening labor market amid strong economic growth.
Financial markets retained much of the same sentiment, with the forward markets expecting the Fed to wait until its July meeting to enact another rate cut.
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On Wednesday, both the federal funds futures market (49%) and the overnight index swaps market (47%) now set the chances of a rate cut before July at less than 50%.
This balanced view is in line with the uncertainty over tariffs, and the ability of the economy to absorb both the drop in demand for labor and its diminished supply as immigration grinds to a halt.
Both markets now expect the first rate cut to occur at the FOMC’s July meeting, with expectations of the Fed holding off any further cuts until next year.
Based on the latest data, we are updating our FOMC rate forecast to expect one 25 basis-point rate cut this year, either at the July or September meeting.
One variable at play is the appointment of a new Federal Reserve chair to replace Jerome Powell, whose term ends in May.
The noise around the central bank’s independence will most likely lead the new Fed chair to eschew a rate cut at the June meeting to avoid the impression that the policy rate is being guided by the executive branch. In that case, a rate cut is more likely to take place in July.
In addition to updating our rates forecast, we are also revising our base case outlook for the economy and our two alternative scenarios:
- Base case: Expansionary fiscal policy should keep spending on a strong footing while continuing deregulation will support enhanced risk appetite and increased business expansion outside of a robust tech sector. Rising overall demand will keep inflation around 3% while the unemployment rate stabilizes around 4.4%.
- Alternative dovish: A government shutdown, continuing geopolitical tensions and rising trade uncertainty are key risks to the economy. If those risks take hold, spending growth will fall below expectations while the labor market weakens. In addition, upcoming benchmark employment revisions could prompt the FOMC to pull forward the number and magnitude of rate cuts.
- Alternative hawkish: Fiscal tailwinds could have a greater impact than expected as tariff concerns ease. Inflation stays above 3% for a while, giving the Fed no reason to cut rates or even alter the balance of risks back toward rising inflation, which would create conditions for a rate increase.
The takeaway
None of the four models that we use to estimate the optimal policy rate implies that a rate cut is needed at this time.
Our preferred model, using the personal consumption expenditures index, implies that the Fed, by having the policy rate to a range between 3.5% and 3.75%, stands roughly 75 to 100 basis points below the optimal rate, which denotes risk of a policy stance that is too accommodative.
Forward markets are predicting one rate cut this year, at the July FOMC meeting. With the economy running hot because of expansionary fiscal policies, that rate cut may be pushed back until September.
But as more information becomes available on the labor market and inflation, policymakers, investors and executives need to consider the range of alternatives when making investment, hiring and portfolio allocation decisions.
