Fed holding pattern continues in the face of rising inflation and unemployment risks

Executive summary

The Federal Reserve (Fed) kept its target federal funds rate unchanged, which was widely expected. Similarly, it maintained the pace of the balance sheet runoff.

The meeting statement acknowledged increased risks to inflation and the unemployment rate stemming from uncertainty about the economy because of policy changes by the new administration, most notably, trade and tariffs.

During the press conference, Fed Chair Jerome Powell stressed that the Fed isn’t in a hurry to change monetary policy, especially given swirling uncertainty. He maintained maximum flexibility.

The initial market reaction was likely overshadowed by the trade war, specifically comments by President Trump that he’s unwilling to preemptively lower tariffs on China to jumpstart trade negotiations but will rescind global chip curbs related to artificial intelligence (AI). 

Ultimately, the Fed remains in ‘wait & see’ mode, which we expect will persist for a while longer. That said, we also believe that the longer the Fed waits, the greater the likelihood that the eventual rate cuts would need to be larger than is widely expected by markets currently.

What happened

At its May rate-setting meeting, the Federal Open Market Committee (FOMC) maintained its target range for the federal funds rate at 4.25% – 4.50%, where it’s been since December.

It will also maintain the pace of its balance sheet runoff (i.e., quantitative tightening, or QT), which was lowered at the beginning of April. The monthly redemption caps on U.S. Treasury securities remain at $5 billion and $35 billion for agency mortgage‑backed securities (MBS).

In his prepared remarks during the post-meeting press conference, Chair Powell noted that backward-looking indicators, such as the labor market and inflation gauges, remain solid and well-behaved. However, it’s unclear if those trends will continue in the coming months due to a high degree of uncertainty with policy changes by the new administration.

Powell reiterated that the committee was "not in a hurry to lower rates" in the near term, which he repeatedly noted during the question & answer portion of the press conference. When confronted with the notion of “why won’t the Fed be preemptive now since it had been in the past?”, Powell deftly listed the many differences between prior episodes and now, including much higher economic growth as well as the rapidly shifting policy backdrop for trade, taxes, immigration, etc. 

Chair Powell quickly shut down questions regarding whether President Trump will replace him and the possibility of staying on the Fed Board after his term as chair expires next year. He also sidestepped questions regarding the federal debt and potential tax changes.

Our Take

As we expected, Chair Powell maintained maximum flexibility – rightly stating that there’s no upside in rushing to do “something” with interest rates. That’s particularly true in the face of ever-changing trade policy and unsettled fiscal policy.

Fittingly, the essence of Powell’s take was that “if you tell me what trade and fiscal policy will be, then we can tell you what we’d do to with monetary policy – but no one can, so neither can we.” Will there be a de-escalation with China, for instance? Will the tariffs cause a reacceleration in prices? Will the 2017 tax cuts get extended? Will the prevailing lousy consumer and business sentiment infect the hard data? The answer to all those and many more related questions is “we don’t know.”

Thus, the Fed remains on hold, which makes sense given the tremendous amount of uncertainty surrounding policy shifts by the new administration for tariffs, immigration, fiscal levers, and regulations. 

We maintain our view that if economic data decelerates substantially, the Fed will reduce interest rates. Given our expectation that inflation will continue its bumpy cooling process, we still expect the Fed to gradually lower the federal funds rate by 75 basis points (0.75%) by the end of 2025.

That said, we also believe that the longer the Fed waits, the greater the likelihood that rate cuts would need to be larger than is widely expected by markets currently.

Bond market reaction

Despite a month and a half of big swings in U.S. Treasury yields, the 10-year U.S. Treasury yield is very close to where it was after the last FOMC meeting (on March 19^th). The tug-of-war between economic growth concerns and uncertain scope and impact of U.S. tariff policy has caused the 10-year yield to stick near 4.25-4.30%. Just like the Fed, the bond market is seemingly awaiting more clarity on where trade policy ultimately lands and its impact to the economy.

Leading into the release of the Fed’s statement and the press conference, U.S. Treasury yields had chopped slightly lower. After the statement, which acknowledged the rising uncertainty to both sides of their mandate, yields took another step lower. The read through to markets was clouded though as President Trump’s statement that tariffs would not be lowered to start negotiations with China came out at the same time as the Fed’s policy statement. After the press conference, where Powell emphasized that the Fed would remain patient, futures markets priced in a lower probability of a cut for June’s FOMC meeting.

U.S. interest rates will remain very sensitive to fiscal policy developments and incoming economic data. Concerns around the potential impact of tariffs and their economic impact may create tactical opportunities to shift portfolio duration; however, these unknowns still support a neutral portfolio duration. 

Bottom line

The Fed remains in a holding pattern with respect to rates. Chair Powell flatly stated that the Fed can’t be preemptive given the current circumstances; most notably, swirling uncertainty. Accordingly, the Fed will continue to sit on its hands.