Opposing Forces Complicate the Fed’s Dual Mandate

At their March meeting, Federal Reserve officials left the policy rate unchanged at 4.25%–4.5% and signaled further patience on rate cuts as they navigate greater uncertainty about the economic outlook. Significant recent changes in U.S. trade, immigration, and other policies prompted Fed officials to revise down their growth expectations and revise up their inflation forecasts.

The revisions left growth in line with their estimates for the longer-term trend, and delayed the projected return to the 2% inflation target. However, the revisions underscore the Fed’s difficult task in navigating both higher inflation expectations and growing concerns about a U.S. downturn. Behavior in financial markets along with survey responses suggest both near-term recession and inflation risks are rising in tandem.

The Fed will want to be careful not to overreact to sentiment, which can change quickly. In the end, we believe the unemployment rate will be the ultimate arbiter: If it’s rising, we expect the Fed will cut its policy rate. However, until then, Fed officials seem comfortable keeping rates on hold and proceeding cautiously, consistent with the majority of officials revising up their 2025 interest rate forecasts.

The signals from the March meeting have us continuing to expect only gradual rate cuts later this year as a baseline, but with growing risks that a sharper slowdown in economic activity forces the Fed to act more swiftly.

Rate path projections revised higher

Significant recent changes in U.S. trade, immigration, and other policies prompted Fed officials to revise down growth expectations relative to their previous projections published in December (leaving growth in line with their longer-term estimates) and revise up inflation forecasts, delaying the estimated return to 2% inflation. Despite the revisions, Fed participants responded that uncertainty was elevated, and risks were skewed toward more inflation and growth adjustment in opposing directions.  

Along with expectations for Trump administration policy pivots to delay a return to 2% inflation, many Fed officials also pushed out their expected timing for a return to neutral policy. The median rate path still showed 50 basis points (bps) of cuts in 2025 and again in 2026; however, underlying that median, 12 officials revised up their 2025 rate path expectations as shown in the dot plot. Although no one expected to be hiking rates, eight participants now forecast being on hold for all or most of the year – up from four who were previously expecting one or no cuts in 2025.

After the March revisions, it would only take two more participants adjusting higher to move the 2025 median rate path.

Troubling trends in U.S. growth and inflation

The March Fed meeting took place against a backdrop of deteriorating sentiment along with rising inflation and recession concerns in the U.S. Prior to the 2024 election, our baseline view was that the U.S. economy would likely slow modestly in 2025 as a more “normal” post-pandemic environment pulled U.S. growth back toward its longer-term trend. However, the initial rush of policy changes from the Trump administration has amplified the near-term downside risks to this slower growth outlook and increased the odds of a slowdown before more growth-friendly policies such as tax cuts are ultimately enacted.

Last week’s University of Michigan consumer survey added to a recent spate of data – including purchasing managers’ indexes, confidence indicators, and the labor market report – that suggest that U.S. growth is slowing while inflation concerns are rising. In the press conference, Fed Chair Jerome Powell noted that while the reported hard data such as unemployment and GDP remain generally stable, “significant concerns” are surfacing in the soft data (e.g., surveys).

Balance sheet shift

The Fed also announced a further slowdown in the pace of its balance sheet roll-down – known as a quantitative tightening (QT) strategy – reducing the monthly redemption cap on U.S. Treasuries to $5 billion per month from $25 billion previously, and allowing mortgages to continue to run off. Powell emphasized this was a technical adjustment, not a monetary policy change. As of late February, the Fed’s reserves stood at $3.3 trillion, slightly below the range our research suggests is necessary for the Fed to maintain a solid floor for overnight interest rate management. Concerns that the debt ceiling’s impact on the U.S. Treasury General Account (TGA) could drain reserves and exacerbate volatility in repo markets reinforce the need for a cautious approach.

We believe slowing QT gives the Fed room to reduce its balance sheet somewhat further instead of outright pausing, although we still ultimately expect QT to stop later this year. In the press conference, Powell called this a “slower for longer” approach. So far, money market rates haven’t shown broad or consistent signs of tighter liquidity conditions (outside of typical month-end movements). However, we expect the Fed will be attentive to the risk of repo volatility.