FOMC meeting: Misery loves company

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Fed keeps policy rates on hold and downgrades economic forecasts

The Federal Open Market Committee (FOMC) once again kept interest rates on hold at its March policy meeting. In its updated projections, the US Federal Reserve (Fed) downgraded its growth forecasts and increased its inflation and unemployment rate forecasts, with the median Committee member still expecting to cut rates twice by the end of this year. Market participants also continue to anticipate a resumption of rate cuts later this year, based on futures pricing.

The range of outcomes for the economy appears quite wide given policy uncertainty, particularly around tariffs. In his prepared statement at the post-meeting press conference, Fed Chair Jerome Powell acknowledged weaker consumer spending patterns but asserted that the Fed is “well-positioned to wait for greater clarity.”

Labor market coming into better balance

With inflation still elevated at levels that I would describe as uncomfortable for consumers and policymakers, it makes sense for the Fed to stay on hold for the time being, despite the emergence of downside growth risks. We have not yet witnessed material weakness in labor markets, as jobless claims remain stable at low levels and the unemployment rate hovers around 4%. The drop-off in labor demand from weaker growth is likely to be matched by reduced labor supply from immigration policies as well as aging demographics. I expect payroll growth to slow in the months ahead but the steady state of payrolls — at levels that do not raise the unemployment rate — will probably decline to a range of 50 – 75 thousand per month.

Sentiment souring, but are consumers really that miserable?

Developments around global trade, US federal outlays, and the federal workforce have weighed on business and consumer sentiment indicators, suggesting a deteriorating growth and inflation trade-off. The inflation expectations component of the most recent survey from the University of Michigan soared by the most since 1993, raising concerns about potential stagflation. However, the results appear to be politically biased, with Democratic respondents reporting much worse sentiment than Republicans. The misery index, ¹ which combines the unemployment rate and inflation, remains well below levels that would raise alarm bells of a stagflationary environment, as actual measures of inflation (as opposed to survey-based) appear fairly well-anchored in the 3% range, still above the Fed’s 2% target.

Some members at odds over balance-sheet policy

The Fed announced a slower pace of the monthly reduction in its US Treasury securities holdings from US$25 billion to US$5 billion. Chair Powell highlighted some earlier disagreement among Committee members about the Fed’s balance-sheet policy, although it sounds like the reduction in pace was very broadly supported. Some considered it appropriate for the Fed to stay the course in winding down its balance-sheet runoff, or quantitative tightening (QT), while others advocated for a pause given potential disruptions from the debt ceiling. Liquidity conditions will likely get a boost with the slower pace of QT and potentially take some pressure off longer-term US Treasury yields. Chair Powell mentioned that the Fed is starting to see signs of tightness in money markets. There is some evidence to suggest that QT is contributing to the relative tightness of supply and demand conditions in the repo market, which makes interest rates more sensitive to changes in Treasury supply.

The change in QT should also ease financial conditions on the margin, which may be welcome to some market participants given the recent equity market sell-off and widening of credit spreads. However, this also threatens to add to existing upside inflation risks. I remain skeptical that the Fed will deliver on market expectations or its own projections for an additional two interest-rate cuts this year unless growth materially disappoints.

¹The misery index was created by economist Arthur Okun in the 1970s as an indicator of economic health.