The Fed and its dueling dual mandate

In no uncertain terms – which may be welcomed in a world of almost nothing but uncertainty – the Fed’s meeting this week was largely inconsequential.

But there were some minor developments that speak to larger themes that we think are worth exploring.

In newly added language to its official policy statement, the Federal Reserve Board noted that, “The Committee is attentive to the risks to both sides of its dual mandate and judges that the risks of higher unemployment and higher inflation have risen.”

Fed Chair Jerome Powell went further in his prepared remarks to note that, “If the large increases in tariffs that have been announced are sustained, they are likely to generate a rise in inflation, a slowdown in economic growth, and an increase in unemployment.”

This theme, of course, is also increasingly being reflected in a wide swath of analyst forecasts. The first chart shows how far RBC Capital Markets’ economists expect inflation to deviate from the Fed’s 2.0 percent annual target, and how far unemployment is seen rising beyond the Fed’s 4.2 percent estimate of the “full employment” rate of unemployment.

Inflation and unemployment both seen exceeding Fed goals, but inflation to a greater degree

Breaking the tension

As Powell noted multiple times during his press conference, the prospects of both higher inflation and higher unemployment create “tension” with respect to achieving the Fed’s dual mandate of price stability and maximum employment, and how it manages its monetary policy tools in doing so.

So, the question then is which mandate will the Fed prioritize when it next decides to act?

Our current thinking is relatively straightforward: The inflationary impacts of tariffs will hit first, and to a greater degree, which has kept – and will likely keep – the Fed on hold until the September meeting. At which point rising unemployment, if realized, will trigger the first of a series of rate cuts – we think three this year followed by three next year – even in the face of elevated inflation. But inflation begins to fade, and unemployment stabilizes, through 2026.

We would hope it goes without saying that even in the best of times forecasts are just that, forecasts. At the moment, any forecast likely isn’t much better than anyone’s worst guess. But this seems like a simple, and fair, framework to be working with.

Are inflation expectations dragging anchor?

Though the Fed noted that current economic growth remains solid and inflation only slightly elevated, the expectations component of both is the next theme which has been featured at recent meetings. Powell has routinely stated that the Fed’s job is to keep the one-time inflationary impact of tariffs from morphing into a persistent inflation problem.

As the second chart shows, that objective appears at risk. Consumer inflation expectations have been rising sharply since the beginning of the year. Though Powell downplayed this at the March meeting as “too soon to draw conclusion,” four months nearly makes a trend, in our view, with preliminary data for May due next week potentially extending it.

Decades of relative stability in inflation expectations upended

Expected change inh prices during next five to 10 years

This dynamic shouldn’t be ignored. In recent decades, the Fed largely achieved its goal of “anchoring” inflation expectations. By and large, expectations, even through the worst of the recent inflation wave, held within a tight range. This break, if sustained, could signal a material shift in consumer psyche as it relates to prices.

We wonder whether, if this round of tariff-induced inflation fears wasn’t coming off the back of an actual inflation wave which has only recently appeared to trough, it might prove to be a one-off episode. But coming so soon after an inflationary cycle could only fuel another where we could see the cycle of businesses raising prices, workers seeking wage gains to offset higher prices, and so on and so forth.

Rising inflation expectations also pose economic risks – if consumers fear higher prices ahead, they may spend now, and that could be what is currently holding up economic activity. But amid rising questions about the consumers’ capacity to spend and growing fears about their willingness, higher consumption now could mean lower consumption later.

Wait and see what may be

While the Fed meeting largely failed to move markets in any direction, the announcement of a framework trade deal with the UK today has done so. The S&P 500 has pushed higher toward 5,700, while the benchmark 10-year U.S. Treasury yield has risen to 4.33 percent.

We have maintained our Market Weight recommendation for both U.S. equities and U.S. fixed income, but recent volatility and market uncertainty present a precarious setup. As of April, RBC Capital Markets projected a year-end S&P 500 closing level of 5,550 – nearly 3.0 percent downside from current trading levels. At the same time, RBC Capital Markets forecasts the 10-year Treasury yield to end the year at 3.75 percent. Bond price appreciation should the yield decline to that level, on top of coupons earned, would imply a total return of just over 7.0 percent.

Should tariff and trade fears continue to ease, there is perhaps some modest upside to both of those forecasts. But in an environment such as this, perhaps it’s best just to follow the Fed’s lead and simply wait and see.

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