Monetary Policy & Inflation | US
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Summary
- Post-‘Liberation Day’ inflation and available hard economic data have been soft.
- Policy uncertainty has fallen but remains high.
- Inflation expectations have fallen or remain consistent with the 2% Fed target.
- The Fed has turned hawkish, possibly due to limited post-tariff data availability and to a perceived need to assert its independence.
- With data softness likely to continue and with Fed independence now well-established, I expect the Fed to turn less hawkish, possibly as soon as the 18 June FOMC if May unemployment rises.
Market Implications
- I expect two-three 2025 cuts starting in July against the market pricing two.
Weaker Inflation and Hard Economic Data
Chair Powell’s last macro-focused public speaking event was the 8 May FOMC. His economic view then was that weaknesses in soft survey data had not yet become hard economic data weaknesses and that inflation remained somewhat ‘elevated relative to the target.’
Since then, inflation and hard data have weakened. Despite an increase in average tariffs to 5.7% in April, up from 2.3% in March, April core CPI printed below expectations for the second successive month. All three components of inflation have continued slowing (Chart 1):
- Uptrend in goods price inflation has stopped. Non-tariffed goods like used cars have been deflating MoM for the past two months (Chart 2).
- Housing cost disinflation has continued.
- Supercore disinflation has continued, driven by a sharp decline in airline fares since end-2024 and, long-term, by slower wage growth that in turn has been facilitated by lower energy prices (for details, see Inflation Monitor).
This reflects factors including:
- Tariffs implementation has only started. The Trump administration is targeting an average tariff of 18%.
- Exporters, importers, wholesalers and retailers have been partly absorbing the tariff increases through margin compression.
- Soft business and consumer demand, a looser labour market and restrictive monetary policy have kept inflation in check.
No post-2 April Liberation Day hard economic data was available when the FOMC was last held. April employment data was collected during 12-16 April, before businesses could react to the administration’s tariff announcements.
Since then, hard data releases have shown weakness. Business spending has been slowing. April core capital goods orders were well below expectations and falling and April capital goods imports fell too (Chart 3).
Consumer spending has been softening too. April real consumption growth slowed due to a sharp increase in the savings rate that, in turn, reflects a loss of consumer confidence (Charts 4 and 5). The April consumption slowdown would have been stronger were it not for a one-off increase in government transfers as a result of changes in social security benefits rules. Excluding transfers, real household income growth is weakening.
The next shoe to drop will be May’s employment report, where the consensus expects headline NFP to slow to 130k from a 155k 3m average and a 193k 6m average. Furthermore, while consensus expects no change in unemployment, the labour market component of the latest Conference Board consumer survey suggests an increase (Chart 6).
I have been expecting hard data weakness since ‘Liberation Day’ because it marked the start of a new regime of exceptional policy uncertainty, high enough to trigger a recession. Since then, policy uncertainty has decreased somewhat but remains high enough to weaken growth.
Lower but Still High Policy Uncertainty, Lower Inflation Expectations
Powell stressed the unusual policy uncertainty at May’s FOMC. The tariffs were much higher than the Fed had expected, which increased equally the risks to both legs of the Fed’s mandate. In managing those risks, the Fed’s overriding objective would be keeping long-term inflation expectations anchored and preventing second-round inflation effects from the tariffs, especially through wages.
Since Powell last spoke, tariff policy has moved lower and somewhat more predictable. The US average effective tariff has fallen to 18% from 28% prior to the 11 May US-China deal that lowered tariffs on China to 30% from previously 145%, a de facto embargo. An easier tariff policy is also shown by Macro Hive’s Tariffs Sentiment Index, which quantifies Trump’s tariffs pronouncements (Chart 7).
Voters’ have reacted positively to this policy turn, which makes it more likely to continue (Chart 8). Toned-down tariff hawkishness is likely the biggest driver behind the decline in the economic policy uncertainty index that nevertheless remains elevated (Chart 9).
Furthermore, legal challenges to the administration’s tariff policy suggest reduced tariff discretion going forward. Court rulings striking down President Trump’s reliance on the IEEPA have been stayed pending appeal. Should the rulings be confirmed, the administration would rely on alternative legal provisions that would constrain tariff policy and make it more process-driven and therefore predictable.
Uncertainty on fiscal policy has also abated. The budget bill passed by the House lowers the deficit by about 60bp of GDP in FY2025 relative to FY2024 but increases it by about 1ppt of GDP in FY2026 relative to FY2025 (Chart 10). This implies a small negative fiscal impulse in FY2025 (i.e., fiscal policy adding more risks to employment than inflation).
I expect the final version of the budget bill to be roughly similar to that adopted by the House, based on the administration continuing to steer the process. The lack of fiscal consolidation has seen the term premium continue to increase (Chart 11). So far, this has not caused much tightening of financial conditions, at least not by the Fed’s measures (Chart 12).
Lastly, since Powell last spoke, inflation expectations have been falling. Short-term market-based expectations have been falling since early-April, in line with energy prices, while long-term market-based expectations have remained stable at levels Powell sees as consistent with the Fed’s inflation target (Chart 13).
By contrast, survey-based expectations have remained high (Chart 14). This disconnect between market-based and survey-based expectations is unusual, as is the disconnect between short-term survey-based expectations and energy prices. Regardless, while survey-based expectations have been rising and now stand around 7%, actual wage growth has been slowing and now stands below 4%. This suggests survey-based expectations will have little impact on the Fed.
Fed to Turn Less Hawkish
Compared with recent data and policy developments, FOMC members generally appear hawkish (Table 1). They note the lack of hard data weakness and stress that employment and inflation risks remain balanced. Also, despite stressing the unusual policy and economic uncertainty, many FOMC members have also offered calendar guidance on when a rate cut might be appropriate. Meanwhile, few have mentioned the two weak inflation prints and the risks of residual seasonality lifting early-year inflation prints.
This hawkishness could reflect two broad factors. First, it is still early days since Liberation Day. Post-Liberation Day hard data weakness has only recently become available. For instance, April consumption was only released yesterday, and capital goods orders on 27 May. Also, the court ruling striking down Trump’s reliance on IEEPA was only issued three days ago. In addition, it will take time for my view that trade policy is becoming less uncertain to become consensus, assuming it is correct.
Second, the Fed is very focused on maintaining its credibility – in Fedspeak ‘keeping long-term inflation expectations anchored.’ This focus is informed by the experience of the 1970s, when the Fed allowed inflation expectations to de-anchor and eventually had to bring about the deepest and most painful post-WWII recession to break them. In this context, Trump’s threats to dismiss Powell could have contributed to the Fed’s hawkishness.
I expect the FOMC to turn more dovish for two reasons. First, I expect the hard data weaknesses to continue because they reflect still-high economic uncertainty. I also expect demand softness to limit second-round effects from the tariffs.
Second, Fed independence is now well-established. Market reactions to Trump’s threats of dismissing Powell have been an effective deterrent. Also, while the Supreme Court has ruled for the administration in the firing of senior officials from independent agencies, it has made a clear carve-out for the Fed. In this context, the recent meeting between Powell and Trump, requested by Trump, is likely to be a step in normalising the relationship. With the Fed reassured that its independence is not in question, it could refocus exclusively on the data.
Whether a dovish turn takes place already at the 18 June FOMC depends largely on May’s employment report, which will be released on 6 June, the eve of the pre-meeting blackout. An increase in unemployment of say more than 10bp could see a less hawkish tone as soon as the 18 June FOMC.
Long-term continued data weakening remains my base case. I also expect long-term BEs to remain consistent with the Fed’s target and inflation and wage prints to show no evidence of second-round effects. In this context, the Fed would be free to focus on hard data weaknesses and would cut in July to reduce recession risks. I think 2025 rate cuts would be risk management cuts rather than the ‘good news cuts’ Governor Waller expects.
Market Consequences
I still see about 40% chance the current economic weaknesses will self-correct or will cause a recession as well as a 20% risk of a US Treasury market crisis. Therefore, I stick to my call for two-three 2025 Fed cuts starting in July. By contrast, markets are pricing only two 2025 cuts and only a 25% chance of a July cut.
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