Another round of the Fed’s waiting game

As was widely expected among the analyst community, the U.S. Federal Reserve held rates steady for the fourth consecutive meeting this year. But it was at the first of those meetings back in January where Fed Chair Jerome Powell, when asked about the potential impact of tariffs on inflation under the incoming administration, uttered what has become his mantra, “You know, there are lots of places where that price increase from the tariff can show up between the manufacturer and a consumer. Just so many variables. So we’re just going to have to wait and see.”

Nothing to see here, yet?

So, after months of waiting, inflation data have only proved to be remarkably tame. Consumer Price Index (CPI) data through May showed headline inflation had been running at an annualized rate of only 1.0 percent over the prior three months, and core inflation (excluding volatile food & energy components) was also running nowhere fast at just 1.7 percent, both shy of the Fed’s 2.0 percent target.

But the Fed, like markets, is only concerned about what the future might hold. Skate to where the puck is going, not to where it’s been, as they say. The Fed’s updated inflation forecasts showed Personal Consumption Expenditures (PCE, its preferred measure of inflation) rising to 3.0 percent by the end of the year, up from a forecast of 2.7 percent in March.

As Powell pointed out in his press conference, it’s not just the Fed that expects the tariff-related impact on inflation finally to materialize later this summer; it’s also most economists, certain market-based measures, consumer surveys, and numerous surveys of businesses.

Indeed, those metrics have indicated that plenty of inflationary risks remain. One such survey from the Institute for Supply Management (ISM) of service-sector businesses showed that when asked whether prices are higher relative to the month before, 45 percent of those surveyed by the ISM reported that to be the case, the most since January 2023.

What is the Fed waiting for?

Companies signal price pressures in the pipeline

That index has tended to lead realized inflation by about three months with a high correlation. And while year-over-year CPI inflation was just 2.4 percent in May, RBC Economics expects that to rise to 2.9 percent in the back half of the year. Other market-based measures from the CPI swaps market suggest the annual rate of inflation could rise higher still to north of 3.0 percent by year end.

Sowing division

Although it may be perfectly fair to ask why the Fed isn’t cutting rates at the current juncture, the Fed’s updated rate projections showed that the median member still expects two rate cuts this year. Of the 19 policymakers on the Federal Open Market Committee, which sets monetary policy, eight projected two 25-basis-point rate cuts by December; at the other end, there’s a growing cohort that sees no rate cuts this year, a group which grew to seven this week from just four back in March.

U.S. President Trump again this week had sharp criticism of Powell and expressed his desire to see 200 basis points of rate cuts immediately, having previously wanted 100 basis points of reductions. He stated that the Fed’s inaction is costing the U.S. “hundreds of billions” of dollars in financing costs.

To be sure, and in no uncertain terms, there is not a political component to any of the Fed’s calculus, in our view.

Yes, the Fed is certainly a powerful institution, but it doesn’t act in isolation and, like so many other things, is not impervious to economic or market forces.

Market forces have also defied the Fed’s actions thus far. Despite already cutting its overnight policy rate by 100 basis points to 4.5 percent from 5.5 percent late last year, the key 10-year borrowing rate for the U.S. (upon which many consumer rates are based) has risen by nearly 75 basis points to around 4.4 percent. Relatedly, the average 30-year fixed mortgage rate has increased by 26 basis points to 6.8 percent.

Despite Fed cuts, key borrowing rates remain higher

Net change from 9/13/24

Put simply, the market is saying via these higher long-term Treasury yields that tariffs raise risks of inflation and that potentially higher deficits, should unfunded tax cuts come to pass, would likely add to those pressures, while also adding to the debt burden – and arguably boosting the growth outlook. All of these things actually limit the Fed’s ability to cut rates.

If the Fed were to cut its short-term policy rates now – at a time of relative economic strength and stability amid a still-solid labour market backdrop – we feel confident that market forces would only propel more of what we have already seen: higher Treasury yields and, consequently, higher government, consumer, and business borrowing rates.

Patience is still a virtue

At the end of the day, however, we would again simply remind investors and clients that, in our view, high interest rates should generally be seen as a positive thing. They are a sign of economic strength and stability. Nonetheless, some in the U.S. would likely love nothing more than a return to the era of free money and low interest rates that prevailed during a time of sluggish growth, elevated unemployment and underemployment, and underinvestment.

As long as the administration’s policies are largely at odds with lower interest rates – for both positive and perhaps not-so-positive reasons – the Fed, though powerful, may be powerless to do anything about it.

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