While The U.S. Federal Reserve has often been quick to cut rates to help support the economy, the current combination of potential inflationary pressures and policy uncertainty may leave the Fed sidelined longer than some investors may hope.

 

Historical rules of monetary policy:

 

1. If the economy dips, take rates down
2. If a crisis hits, take rates to zero
3. If the crisis extends, buy U.S. government bonds

 

Considering this, it’s understandable that some investors think the Fed will once again jump to the rescue if economic growth slows through the balance of the year.

 

It’s that mindset which has interest rate futures showing a near certainty that the Fed cuts rates at least once and possibly twice by July, adding to last year’s 100 basis points (bps) of cuts.

 

As encouraging as that may sound, implementation may be anything but simple.

 

Investors should be prepared for a Fed that may take a more deliberate approach to rate setting than current pricing reflects. A slower-acting Fed may create volatility, but a go-slow approach is ultimately likely to be beneficial for the economy and markets.

 

Stagflation – What Does This Mean ?

The problem here is that the Fed is likely to face pressure on both sides of its mandate to seek full employment consistent with price stability.

 

If forecasts are correct, the balance of the year will see essentially flat growth, with consumer prices rising at an annual rate approaching 4%.

 

The idea that the Fed be lowering overnight rate targets when inflation is above 3%—is problematic for several reasons:

 

• Confirming Expectations: Central bankers tend to focus on consumers’ medium-term inflation expectations. The theory is that when the market expects inflation, it becomes a self-fulfilling prophecy. Households that expect rising prices tend to spend more quickly and demand higher wages, both of which can create upward price pressure. Historical data supports this.

 

• Punching Jello: If the economy is slowing because of policy uncertainty and the impact of tariffs, a 25 bps rate cut is not going to do much. Lower financing costs are great, but for a company with 125% higher input costs, will mean that there’s insufficient demand for their product at any profitable sales price. Rate cuts will do little to solve this.

 

• Steeper Yield Curves: Although the Fed targets the rate for overnight loans, very little real economic activity is funded with daily borrowing. Corporate investments typically look to 10-year bond yields as they calculate the costs and potential profitability of a project. A preemptive central bank rate cut could raise concerns that the Fed is not giving sufficient weight to its inflation mandate, and cause investors to demand higher long-term yields. If that happens, many would expect to see investment choked off, adding to growth and employment concerns.

 

In summary, there is limited benefit for the Fed to aggressively cut rates while inflation and inflation expectations are elevated.

 

Another difficulty for the Fed in making policy based on where the economy is going is that critical inputs are changing with nearly unprecedented speed.

 

Tariff policy and game-changing levels of reciprocal tariffs (currently paused), can and have changed in the blink of an eye. This dynamic is likely to continue. U.S. economic growth looks very different if the delay resolves with negotiated trade deals than if most of the so-called reciprocal tariffs are eventually implemented.

 

This uncertainty raises a major difficulty for the Fed.

 

If it moves to cut rates ahead of the data based on high tariffs, it could find the rationale for that cut removed by a subsequent policy move. Taken to the extreme, this could lead the Fed from a rate cut to rate hikes in very short order, potentially within one or two meetings.

 

The Fed’s end goal is to provide confidence both in the overall economy and in the value of the dollar. Rapid shifts in policy aren’t conducive to confidence building. The central bank will prefer to wait and be sure versus moving quickly based on the shifting sands of fiscal policy.

 

Two paths exist for the Fed to move rates lower.

 

1. Drop In Inflation Expectations that gives the Fed both comfort and a strong policy argument for lower rates, even if the latest inflation numbers are above target. The actual trigger levels for action will depend on the combination of unemployment, leading economic growth indicators, current inflation, and inflation expectations. Contained inflation expectations are a prerequisite for early action.

 

2. Slower Growth and Rising Unemployment In this case, expect the slow start to be matched by more aggressive action, with the Fed willing to entertain larger moves, as seen in the previous rate cutting cycle.

 

A risk that a Fed that fails to cut as quickly as expected could be perceived as markets losing a pillar of support, potentially creating short-term volatility. This view underestimates the challenges facing the central bank.

 

A focus on inflation and inflation expectations is likely to be more effective path in the long run.

 

If you have any questions or comments, please let me know.