FOMC Preview: Fed to Turn Dovish

Summary

• The Fed can focus on its mandate now Chair Powell is no longer at risk of getting fired, which increases the chance of a rate cut.
• It is unclear the Fed still needs to wait for more information on the Trump administration policies because no matter what these turn out to be, their impact will likely be dwarfed by that of the enormous policy uncertainty already generated.
• A slowdown is already underway, though tariff frontrunning partly hides it.
• Most tariffs will likely be implemented in May yet import prices are already slowing while long-term inflation expectations remain stable.
• These data align with Fedspeak recently turning dovish, suggesting a June cut for risk management.
• The reemergence of funding strains suggests the Fed could slow or end quantitative tightening (QT).

Market Implications

• I still expect six cuts, starting in June and mostly in 2025, against markets expecting four cuts in 2025.

Fed Independence Raises Risk of Policy Easing

On 16 April Powell stated that, despite soft data weaknesses, hard data remained solid with the labour market still at full employment and that inflation remained above target. He stressed the Fed’s ‘obligation’ was to keep long-term inflation expectations anchored and prevent the tariffs’ second round effects. Because the administration policies were ‘still evolving’, the Fed needed to wait and see to update its assessment of their impact.

Four key developments since then:

• President Trump has accepted he cannot fire Powell.
• Informational value of waiting has decreased.
• Data so far shows higher risks to employment than inflation.
• Fedspeak has turned dovish.

Trump announced last week he had no intention of firing Powell, a marked departure from earlier threats to do so. Markets have widely viewed this as the Fed winning the staring contest with the White House.

Trump’s move on the margin actually increases risk of policy easing. This is because the Fed no longer must prove its independence, freeing it to concentrate on its mandate, specifically the response to the slowdown.

Wait and See No Longer Beneficial

In his 16 April speech, Powell listed trade, immigration, fiscal policy, and regulation as areas where the administration ‘is in the process of implementing substantial policy changes.’ He stressed substantial uncertainty remained on the nature of these policies and their impact on the economy. Therefore, the Fed is in a wait and see mode.

I think that wait and see mode is obsolete because the negative impact of the uncertainty and complexity the administration has generated dwarfs that of any specific policy changes it may be planning.

Measures of uncertainty hitting new highs despite the announcement of the reciprocal tariff pause on 2 April (Chart 1) shows this. It can also be seen with the administration attempts to walk back tariff policies, which are only adding complexity.

For instance, the lightening of automotive tariffs relies on complex calculations based on the value of a US made car and on multiple and costly submissions to the Commerce Department. A substantial increase in federal employees will be required for monitoring and compliance, together with a substantial increase in compliance officers in tariff-hit industries.

Similarly, the administration seems to be moving towards a common template in its negotiations with the 70 countries seeking a deal. This is implicit recognition that negotiating with 70 countries is difficult and that striking a deal takes time – trade deal negotiations typically last multiple years.

And because of disregards for past US trade agreements and international rules, risk exists the administration could have lost credibility.

Ultimately, even if the administration was willing to walk back complexity and uncertainty, it probably would be unable to do so at least in a time frame that could halt the slowdown.

The extraordinary surge in uncertainty initially hit only ‘soft’ survey data (Chart 2) but has now transmitted to hard economic data.

Tariff Frontrunning Hides Demand Weaknesses

Since Powell’s speech, signs of a slowdown have become more pronounced, though tariff frontrunning partly hide its extent.

Q1 GDP at -0.3% QoQ SAAR was negative as expected, on account of large imports of goods ahead of the tariffs. The contribution of net exports and inventories change was -3.2ppt (Chart 3). Final demand increased by a robust 2.3% QoQ SAAR. However, most this increase was accounted for by consumers and businesses spending an abnormally high amount on goods. This is bearish because such high spending on goods will be offset later in the year by an equivalent decrease.

Despite higher goods spending, overall consumption growth has been slowing sharply, as a result of a higher savings rate that itself reflects the surge in uncertainty (Chart 4).

The labour market also shows the slowdown, which tariff frontrunning does not directly impact. The labour differential index of the just released Conference Board consumer confidence survey points in the direction of an increase in unemployment, as does Sam’s forecasting model (Chart 5).

Yet, the slowdown is still in its early stages. A critical indicator of whether the slowdown will morph into a recession is likely to be labour income (i.e., employment and wages). A marked slowdown in labour income could trigger a negative feedback loop between employment, household income, and consumption. The feedback loop in turn could push the economy into a recession (Chart 6).

My base case remains a recession, largely because policy uncertainty and complexity cannot be easily unwound.

Import Prices Slowing Ahead of Tariff Implementation

The full impact of tariffs has yet to arrive. The average effective tariff (AET) in March was 2.4%, virtually unchanged from February’s 2.2%. Daily Treasury data on tax collections shows about a 40% increase in tariff revenues in April. This would make for an AET of about 3.5% assuming unchanged exports. This compares with an AET of about 25% following the 9 April pause in reciprocal tariffs. Most of the tariff increase is still ahead.

Nevertheless, goods import price inflation has been slowing ahead of tariff implementation, possibly because of demand weaknesses (Chart 7). While core PCE remains well above the Fed’s target, March surprised on the downside (Chart 8). Long term, the recession I expect is likely to cap any second-round effects of tariffs on prices.

Meanwhile, long-term market-based expectations remain well anchored, while survey-based expectations are de-anchoring (Charts 9 and 10). However, the Fed has clearly indicated it was focused on the former rather than the latter.

Against this economic and inflation backdrop, financial conditions have tightened, which could have amplified the restrictiveness of the Fed’s policy stance (Chart 11). Also, business and household borrowing has remained low, suggesting the recovery has not been credit driven (Chart 12).

Dovish Fed Turn Likely

Macro Hive’s Fed LLM Sentiment Index shows Fed speakers have turned dovish (Chart 13). This is consistent with rising growth risks, stable long-term inflation expectations, and tighter financial conditions.

Since the Fed has already signalled it would stay on hold in May, a June Fed cut seems likely based on risk management (i.e., balancing recession risks against the risks of the second-round tariff impact). Further Fed cuts would depend on the pace of the slowdown. Chart 14 shows a scenario with a June cut, a July pause, a September cut and 50bp cuts in October and December as evidence of recession becomes stronger.

Therefore, I expect the tone of next week’s FOMC to turn noticeably more dovish. This could be achieved through downgrading the economic assessment in the statement and the presser, as well as hints that June could be in play ‘if the data is clear’ as Cleveland Fed president Hammack stated a week ago.

QT to Slow Further

Lastly, I expect the Fed to slow QT further. A month ago, I highlighted the Fed balance sheet is likely already too small relative to the needs of its operational system.

The Fed operates with an abundant reserves framework. However, because of the interconnectedness of the money market segments, the Fed must provide liquidity to the entire money markets, not just banks. A broad measure of Fed liquidity provision applied to the broad money market suggests liquidity is tighter than 2019’s Q3, when money market volatility exploded (Chart 15).

Funding strains have reappeared since I discussed the Fed’s balance sheet, even though the TGA run down continues injecting reserves in the banking system (Chart 16).

Slower QT could be achieved through ending Treasury roll offs altogether, currently $5bn/month. However, MBS continues rolling off the balance sheet at a pace of about $15bn a month. Since the Fed no longer wants to hold MBS, it could continue this roll off but restart Treasury purchases to partially or totally offset it.

Market Consequences

I still expect six cuts, starting in June and mostly in 2025, against markets expecting four cuts in 2025.

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