Economists Anticipate Steady Interest Rates Amidst Economic Uncertainty
Despite a contraction in the nation’s economy during the first quarter, expectations are low for the Federal Reserve to signal imminent interest rate cuts at its upcoming meeting. Economists widely predict that Fed officials will maintain current rates and reiterate their cautious approach, emphasizing the need for further economic clarity before considering any rate adjustments. The prevailing sentiment suggests the Fed will closely monitor the effects of President Trump’s tariffs on its dual mandate of price stability and full employment.
While the U.S. gross domestic product (GDP) technically decreased in the first three months of the year, the underlying economy is considered fundamentally sound. However, inflation remains moderately above the Fed’s 2% target, and the imposition of tariffs is expected to exacerbate price pressures.
Typically, a robust economy and strong job market contribute to inflationary pressures, prompting the Fed to raise interest rates or maintain them at elevated levels to curb economic activity. Conversely, a slowing economy or recession tends to restrain price increases, leading the central bank to lower rates to stimulate growth and job creation.
However, Trump’s sweeping tariffs are projected to significantly increase consumer prices, thereby reducing household spending. This scenario presents a challenging situation known as stagflation, where the Fed faces conflicting mandates. Consumption accounts for a substantial portion of economic activity and drives job growth.
Fed Chair Jerome Powell has previously stated that the Fed would prioritize the mandate that is further from its objective, whether it be stable prices or maximum employment, in the event of a conflict between the two.
Analysts anticipate that Powell will likely acknowledge the potential for conflicting objectives and suggest a balanced approach. However, he has also indicated that the Fed’s primary obligation is to maintain stable long-term inflation expectations, ensuring that the one-time price increases resulting from tariffs do not lead to persistent inflation.
Several financial institutions have weighed in on the Fed’s likely course of action. Morgan Stanley expects the Fed to prioritize price stability, while Deutsche Bank believes that the labor market will need to exhibit signs of weakening before the Fed contemplates any further rate reductions.
Market expectations, as reflected in Fed futures markets, anticipate the Fed to resume rate cuts in July and implement three quarter-point cuts by the end of the year. However, other forecasters have become more cautious, with Barclays pushing back its estimate for the first rate cut and projecting fewer rate decreases overall. Morgan Stanley, on the other hand, predicts no rate cuts until 2026 unless the economy experiences a recession this year.
The Fed previously lowered rates by a percentage point in late 2024 after a pandemic-related inflation surge subsided, but has since paused as the import levies threaten to reignite price hikes.
Several factors contribute to the likelihood of Fed officials signaling a prolonged pause in rate reductions. While the economy contracted in the first quarter, this was largely attributed to a surge in goods imports as companies sought to acquire foreign merchandise before tariffs took effect. Imports are subtracted from U.S. GDP calculations because they are produced in other countries.
Goldman Sachs anticipates that this effect will reverse in the second quarter, leading to increased growth. Additionally, consumer spending and business investment demonstrated solid growth, indicating that the economy’s fundamental drivers remain strong. Final sales to domestic purchasers, excluding trade and inventories, also experienced healthy growth.
Although some consumer and business purchases were aimed at anticipating tariffs, the underlying demand from households and companies was evident. Furthermore, U.S. employers added a significant number of jobs in April, and the unemployment rate remains at a historically low level.
The Fed is expected to disregard some of the short-term fluctuations in GDP data caused by trade policy uncertainty. Inflation also showed signs of moderation in March, with the Fed’s preferred overall inflation measure and a key reading excluding volatile food and energy items both declining.
Despite this encouraging development, inflation remains above the Fed’s 2% target. Moreover, tariffs are expected to significantly increase inflation by midyear. Analysts estimate that core inflation will peak at 3.8% in 2025.
Although consumer and business confidence have declined amid tariff announcements and stock market volatility, sentiment also experienced a downturn when the Fed aggressively raised interest rates in 2022 and 2023. However, this did not result in a recession, raising questions about the reliability of sentiment polls.
Fed officials are expected to seek evidence from labor market data and other hard indicators before implementing rate cuts. John Williams, head of the Federal Reserve Bank of New York, anticipates inflation to rise to 3.5% to 4% this year, followed by an increase in unemployment to 4.5% to 5% over the next year.
It will be challenging for the Fed to cut rates to avert a potential labor market decline if inflation rises first and is further from its target than employment is.
Trump’s immigration policies, which involve the deportation of undocumented immigrants, are likely to slow down labor supply growth. A smaller pool of job seekers could result in a slower increase in the unemployment rate, even as hiring slows and layoffs increase. This could make it more difficult for the Fed to cut rates, particularly in the face of rising inflation.
Goldman Sachs, however, believes the Fed could move sooner and more forcefully to reduce rates. Intensifying business uncertainty could lead to less hiring, more layoffs, and the first signs of weakness in the May employment report. Meanwhile, businesses worries should lead to fewer job openings and less capital spending within a couple of months. Goldman thinks the Fed will start cutting rates in July and lower rates three times this year.
