FOMC Preview: 2025 Dot to Show One Cut

Summary

• Since May’s FOMC, soft data weaknesses have started transmitting to hard data and the impact of tariffs on inflation has been limited, though it is early days.
• FOMC members’ overall objective is to prevent a de-anchoring of long-term inflation expectations and a permanent inflation increase.
• The SEP is likely to still show a soft-landing scenario but with higher inflation and only one cut in 2025 followed by a resumption of disinflation and three cuts in 2026.

Market Implications

• I still expect two-three cuts in 2025, starting in September against markets expecting 1.7.

Soft Data Weaknesses Transmitting to Hard Data

Participants agreed at the 7 May FOMC that:

• Tariffs had been higher than they expected.
• ‘Soft’ survey data weaknesses had not yet been transmitted to hard data.
• Inflation ‘remained somewhat elevated.’
• Uncertainty around the outlook was unusually elevated.
• Upside risks to inflation and unemployment had increased.
• Fed policy was well-placed to wait and see.

Since then, soft data weaknesses have started transmitting to hard data with growth slowing and the labour market showing early signs of softening (Charts 1-4). While it is early days – April’s average tariffs were only about 6% against the Trump administration’s 18% target – inflation has been muted. Also, no signs exist of accelerating prices of non-tariffed goods or services (Chart 5-6), which I will discuss in my review of Wednesday’s CPI.

Meanwhile, policy uncertainty has decreased. A court ruling striking down President Trump’s reliance on the IEEPA to impose tariffs could make tariff policy more predictable. In addition, the budget going through Congress shows fiscal restraint in 2025, followed by fiscal expansion in 2026 (Chart 7-8).

Chart 1: Confidence Remains Weak	Chart 2: Growth Is Slowing
Chart 3: Employment Growth Is Slowing	Chart 4: Broad UR Is Rising
Chart 5: Exporters ‘Eating’ Tariffs	Chart 6: Slowing Services Inflation
Chart 7: Tariffs Could Become Less Volatile	Chart 8: Small Budget Consolidation in 2025

Long-term Inflation Expectations Remain Anchored

Against these developments, FOMC members agree on two overarching objectives: keeping long-term inflation expectations anchored and ensuring tariffs have no lasting impact on inflation (Table 1). However, they differ on how to reach these goals.

The 1970s inflation experience informs the Fed’s concern over the de-anchoring of long-term inflation, when the Fed lost credibility and allowed core PCE to rise above 10%. Breaking down the inflationary cycle required the deepest recession since WWII and the Fed does not want a repeat.

Market-based inflation expectations have remained well-behaved (Charts 9 and 10). By contrast, survey-based expectations have de-anchored.

Overall, the Fed is likely to consider market-based expectations as the more reliable indicator. This has been Chair Powell’s view for some time. Also, Governor Waller has recently stressed that de-anchoring of survey-based expectations have not prevented wage disinflation and therefore may not reflect consumers’ inflation views. Based on recent Fedspeak and the minutes, de-anchoring of expectations appears to be a concern for ‘some’ rather than most FOMC participants.

However, St Louis Fed President Musalem noted political interference could threaten Fed credibility and the anchoring of expectations, which may delay Fed easing. Musalem was likely referring to Trump’s criticism of the Fed’s unwillingness to cut rates.

FOMC Divided on Inflation Risks

The FOMC has less consensus on assessing risks of second-round effects from tariffs (i.e., tariffs could cause a permanent increase in inflation rather than in the price level). Powell and most of the FOMC see the second-round effects as less likely if the tariffs are lower; businesses pass them on quickly into prices, and long-term inflation expectations remain well-anchored.

Meanwhile, Waller sees second-round effects as unlikely due to:

• Softening labour market.
• Tighter monetary and fiscal policies (budget deficit is large but not increasing) than during the pandemic.
• Absence of shortages. Here, the recent-de-escalation with China is very positive.
• Well-anchored inflation expectations.

By contrast, Governor Kugler is less optimistic. She thinks ‘it is unclear whether the tariffs will have a onetime inflation impact’ and she sees inflation as more of an immediate risk than unemployment.

Musalem and many FOMC members fall between these two scenarios. Musalem sees a 50% chance of second-round effects.

The FOMC’s growth view has started shifting. Kugler and regional Fed presidents Bostic (Atlanta), Kashkari (Minneapolis) and Musalem (St Louis) have noted early signs of labour market weakening. This could explain why Macro Hive’s Fed LLM Sentiment Index is signalling a more dovish tilt to Fedspeak (Chart 11).

Still Soft Landing but 2025 Dot to Show Only One Cut

A rate cut is not in play next week, but the FOMC will update the SEP.

The timing of the FOMC’s easing cycle is its main instrument to keep inflation expectations well-anchored and prevent second-round effects. Despite talk of inflation risk, no FOMC member has raised the possibility of ending the Fed’s easing cycle. Rather, the more hawkish FOMC members are likely to delay Fed easing (i.e., the dots distribution is likely to shift right (Chart 12). Therefore, I expect the median dot to show only one 2025 cut but three 2026 cuts, from two and two in March’s SEP.

This is based on the SEP still showing a soft-landing scenario though with higher 2025-26 inflation than in March’s SEP (Table 1):

• Uncertainty has not decreased much so it would be hard to justify a very different scenario.
• Showing a hard landing or no landing could expose the Fed to criticism that its policy is too tight/loose. This is an inherent issue with the SEP that conveys more certainty and control than the Fed actually has. Academics including former Fed chair Bernanke have suggested the Fed would be better off relying on scenarios.

Table 1: June SEP to Show Soft Landing

(Forecast June SEP, March SEP in Brackets)

Chart 11: Fedspeak Turning More Dovish	Chart 12: Dots Distribution to Shift Right

Market Consequences

I still expect two-three 2025 cuts starting in September because I am more optimistic on inflation and more pessimistic on growth than the FOMC. This compares with markets currently pricing 1.7 cuts by December.

Even though the administration has been moving towards trade de-escalation, policy uncertainty remains high, and businesses and consumers have suspended planned expenditures. This is taking time to appear in data partly because the economy met ‘Liberation Day’ with strong momentum.

I do not expect the slowdown to stop because private confidence has been damaged and will take time to be restored. In addition, the administration has already started implementing tighter student loan policies and a limited budget consolidation this year that will weigh on growth. Therefore, I still see equal risks the slowdown will self-correct or will lead to a recession.

Because I expect the slowdown to continue, I agree with Waller that second-round tariffs effects are unlikely. By September’s FOMC, I expect data to have shifted the balance of risk between inflation and employment in such a way as to enable a cut.

Table 2: Recent FOMC Comments

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