SUMMARY
The US central bank held rates at its May meeting. For now, it seems likely to stay focused on inflation.
KEY TAKEAWAYS:
The Fed is waiting and seeing the impact of tariffs on the economy
Futures markets recently suggested three 25bps Fed cuts this year
In balanced portfolios, we make the case for fixed income holdings with intermediate average duration
The Federal Reserve kept its Fed Funds rate in the 4.25-4.50% target range on May 7. That was the third meeting in a row where it held rates steady.
Alongside this decision, the US central bank commented on potential negative tariff impacts. It mentioned that “uncertainty about the economic outlook has increased further.” In the Fed’s view, “risks of higher unemployment and higher inflation have risen.”
Chairman Powell elaborated on these risks at his press conference, saying that tariffs, if sustained, “are likely to generate a rise in inflation, a slowdown in economic growth and an increase in unemployment.”
Economic data still set to worsen
We share the Fed’s view: all it can realistically do is “wait and see and to watch” on when and how tariffs will affect the US economy.
For now, key indicators such as unemployment and inflation indicate a slowing albeit still positive economy.
That said, sentiment surveys are very poor. Economic data later this year seem likely to look much worse than first quarterly data.
This suggests more dire economic forecasts from the Fed at its upcoming June meeting.
When will the Fed cut interest rates?
Immediately after the Fed announced its decision, the futures market signaled three 25 basis points (bps) rate cuts in 2025, and perhaps two more rate cuts by the end of 2026.
Ordinarily, worsening data would argue for the central bank to cut interest rates soon. However, tariffs at any level are likely to push up inflation, if only to begin with.
And the Fed remains primarily focused for now on containing inflation, even at the expense of a weaker economy.
As Chairman Powell said: “It is also possible that the inflationary effects could instead be more persistent. Avoiding that outcome will depend on the size of the tariff effects, on how long it takes for them to pass fully into prices and ultimately on keeping longer-term inflation expectations well anchored.”
The Fed is also likely considering the recent steepening of the Treasury yield curve, i.e. the widening difference between short- and long-term interest rates, driven by a rise in the latter.
If it resumed cutting shorter rates, the market might see that as overly stimulative for the economy. In response, longer term yields could rise again.
Any sharp steepening could provoke fears around financial stability.
Higher longer-term yields would also mean heavier borrowing costs for the US government.
This is the last thing it needs. The US is already borrowing heavily to finance a 7% fiscal deficit. And it may have to issue even more bonds if the deficit swells further.
Given all this, the Feds’ safest decision is probably to let hard economic data be its guide. As Powell said: “I don't think we know now. Policy is modestly restrictive. We don't need to be in a hurry and can watch the data.”
Considerations
We make the case for fixed income holdings within balanced portfolios that maintain intermediate average duration. Once the Fed does resumes cutting, short-to-intermediate term rates will likely decline somewhat. The likes of intermediate duration bonds may benefit, in our view. They are also potentially less at risk if long-term rates rise in future.
