FOMC Watch - Forward-looking Fed holds rates anticipating rising inflation
The FOMC held rates in the 4.25-4.5% range, as expected. The press release stated that they judge that "uncertainty about the economic outlook has diminished but remains elevated, " consistent with the de-escalation in the trade war with China a few days after the May FOMC meeting.
In their quarterly projections, they raised the median estimate for inflation at the end of 2025 to 3% form 2.7%, and marked down growth from 1.7% to 1.4%. The unemployment forecast was raised to 4.5% by year end, up from 4.4% in March. These forecasts are all within 0.1% of our own. The previous round of projections was released before Liberation day. The 0.3pp increase in inflation is indeed quite substantial when considering that headline PCE inflation was at 2.6%, while now it stands at 2.1% after a series of low readings. Their base case is for inflation to be transitory, with inflation dropping back to 2.4% next year, and 2.1% in 2027. After making these changes to their forecasts, a few members now judge the risks around their forecast as broadly balanced, rather than weighted to the upside, although the vast majority still sees them as weighted to the upside.
The dot plot, which provides the members' most likely trajectory of the future policy rate, showed no change in the median forecast for end-of-year rates, but the distribution did change. In March, four members thought there were going to be no rate cuts, which rose to seven this meeting. Two members expect one cut, and a further eight still expect two cuts. The average expected amount of rate cuts dropped from 1.47 to 1.26. Further hawkishness can be seen in the end of 2026 projection where the median member now sees an upper bound to the rate of 3.75, meaning three rate cuts, while last time nine out of nineteen members thought it would be at 3.50. The average number of cuts until end of 2026 went form 3.68 in March to 3.11 now. The trend is clear.
In the press conference, Powell reiterated that the effects of the administration's policies on tariffs, immigration, fiscal policy, and regulation remain uncertain. He noted that the effects of tariffs will depend on the ultimate level, but will weigh on inflation and economic activity in any case. The effect could be short-lived, a one-time shift in prices, but Powell noted that it's also possible that inflation would be more persistent, ultimately depending on whether inflation expectations remaining anchored. For the time being, they judge themselves to be well positioned to learn more before considering any adjustments in the policy stance.
Chair Powell noted that he expects the impact of tariffs to reveal itself more strongly over the summer, which will inform their thinking. He noted that the levels of tariffs are simply unprecedented, and as a result they should be humble about how well they can forecast the impact. Moreover, there is still uncertainty about what the effective tariff rate will be, and the process of pass-through of tariffs is uncertain as well. He noted there are many parties in the chain, none of whom want to pay the bill, but ultimately, they jointly have to. But still, the amount, size, duration and time it will take are all highly uncertain. In a question about how this related to the bi-modal view in the dots plot, with two large groups favouring zero or two cuts, Powell noted that these are largely consistent with different forecasts. Higher inflation implies fewer cuts. But he beliefs those differences will resolve once the data provides them with more information.
Powell was also asked about recent softer data, which we also mentioned in our . He agreed that backward looking policy would bring you towards a neutral stance and would allow for rate cuts. But 'monetary policy has to be forward looking.' They expect inflation to rise, and the labour market is not crying out for a rate cut. Overall, he continued to push back against any near-term policy rate changes, noting 'We'll make smarter and better decisions once we have a better sense of the pass-through to inflation, and the effects on spending and hiring.' Based on his answers, an absolute lower bound for any rate action appears to be after the summer, but it seems unlikely that this single quarter of extra data will provide them with the confidence to cut rates. We maintain our view that the Fed is unlikely to cut this year, on the back of a combination of higher inflation, risk of inflation expectations de-anchoring, and a labour market downturn that is muted by a decrease in labour supply.