FOMC Review: Keeping Policy Optionality and Markets Happy

Summary

• The Fed remained on hold and kept two 2025 cuts in the SEP as I expected.
• Powell’s growth views were ambiguous as he appeared less pessimistic than the SEP.
• Powell’s base case is for the tariffs inflation impact to prove transitory, though he stressed uncertainty was unusually high.
• The FOMC policy consensus grew stronger and more hawkish.
• The Fed slowed quantitative tightening (QT) to limit money market volatility around the debt ceiling resolution.

Market Implications

• I still expect no cuts in 2025 against markets pricing about 2.7 cuts.
• My view is based on administration policies becoming more predictable. I will change my call If this does not happen soon.

Lower Growth

As I expected, the Fed stayed on hold and kept two 2025 cuts. The Fed stressed the unusual policy uncertainty while it also changed the SEP to show a stagflation-lite scenario: higher inflation and slower growth (the 1970s full-fledged stagflation involved recessions).

Powell’s message on growth was mixed. He stressed during the presser that most of the recent weakening was with soft data, ‘we do see pretty solid hard data still’ and ‘the relationship between survey data and actual economic activity hasn’t been very tight.’

However, the SEP showed a markedly slower growth path, especially in 2025 (Table 1). In addition, 18 out of 19 participants saw risks to growth tilted to the downside, against five at December’s FOMC.

Furthermore, the increase in the 2025 unemployment rate was small relative to the growth downgrade. The SEP showed unemployment increasing by 10bp to 4.4% relative to the December SEP, despite 2025 growth being lowered by 40bp to 1.7%.

Historically, 4.4% unemployment is low and only 20bp above the Fed’s estimate of the long-term unemployment rate. That is, despite the growth slowdown, the Fed still expects the economy to remain at full employment.

The combination of slower growth and full employment could reflect the impact of lower immigration. It implies lower aggregate supply and demand and therefore is consistent with slower GDP growth and full employment.

Lastly, asked about the impact of the ongoing equity selloff on the outlook, Powell stated that a change in financial conditions would have to be persistent to materially impact the economy.

Temporarily Higher Inflation

The Fed’s inflation views were clearer. Powell explained his base case is for tariffs to delay the resumption of disinflation but to have only a transitory inflation impact. This was consistent with the SEP showing 2025 core PCE higher by 30bp relative to December’s SEP but remaining on a similar trajectory thereafter. Also, 18 out of 19 FOMC participants saw risks to core PCE tilted to the upside, against 15 at December’s FOMC.

In addition, Powell stated it was too soon to determine whether tariffs would raise inflation rather than have a one-off impact on the price level. He did stress, ‘we’ve had two very strong goods inflation readings in the last two months, which is very unexpected’ and ‘If higher goods inflation turned out persistent, then it must be to do with people raising prices ahead of tariffs.’

Hawkish Policy Tilt

Despite no change in the median dot, changes to the distribution signaled a stronger consensus and a more hawkish policy outlook. The median 2025 dot was unchanged but the average increased (Table 2). Also, the range of forecasts narrowed.

Powell was asked how the Fed would adjudicate its employment and inflation mandates that, as shown by the SEP stagflation lite scenario, were pulling policy in opposite directions.

Powell’s answer was ambiguous. While he referred to the Fed’s consensus statement and said ‘we will look how far each of those two goals is from its goal, and then we’ll ask how long we think it might take to get back to the goal for each of them.’

But when asked why the SEP still showed two 2025 cuts despite expecting core PCE at 2.8%, Powell answered a ‘tick up in unemployment’ offset the increase in inflation. This does not seem a strong answer as even after ‘tick up’ the FOMC still expects full employment.

Lastly, Powell repeated the Fed was in no rush to change policy and that decisions would be taken meeting by meeting.

Slower QT

As Wall Street Journal reporter Nick Timiraos announced, and contrary to my expectations, the Fed slowed QT with the reinvestment cap on treasuries lowered to $5bn from $25bn previously. The MBS cap was unchanged.

Powell explained running down the TGA was adding to reserves that could hide signs of reserves scarcity. He further explained this constituted a permanent slowdown rather than a pause and would not change the final size of the Fed’s balance sheet.

I think this move reflects that the RRP balance is nearly zero and, in this new context, the Fed is more worried than I thought about the impact of shrinking its balance sheet on money market liquidity. By contrast, in 2023 the RRP balance was $2.3tn and the RRP entirely absorbed the rebuilding of the TGA (Chart 1). Also, the administration’s planned banking deregulation will aim to encourage more lending and therefore implies less bank liquidity parked in money markets.

Market Consequences

Overall, Powell kept his policy optionality and markets happy, for now.

Markets liked this FOMC. The Dec 2025 FFR and 2yr yields fell 11bp, the 10yr yields by 7bp, while the SPX ended the day up 0.9%.

I think the market is overestimating Fed dovishness. Powell stated both that a transitory impact of tariffs was his base case and that it was too soon to be confident as uncertainty was exceptionally high. The market focused on the former rather than the latter.

This FOMC was more hawkish than I expected. It highlighted inflation risks more than I expected (even in a hawkish scenario I expected the SEP to keep two 2025 cuts). In addition, Powell showed more confidence in the growth outlook than I expected.

I agree with Powell that so far economic weakening has been mainly with soft survey data rather than hard data. If the administration moves to more predictable policy implementation, confidence could improve, which would raise soft data and prevent the hard data weakening of the hard data. I will change my call for no Fed cuts in 2025 if there is no such improvement over the next few weeks.

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