Monetary policy possibilities

By Atul Bhatia, CFA

For the past 20 years, setting U.S. monetary policy looked more like checkers than chess. The rules were simple: if the economy dips, take rates down; if a crisis hits, take rates to zero; if the crisis extends, buy U.S. government bonds. The one time inflation popped up as a serious problem, it was still straight-forward. The Fed could play bad cop and hike rates, since the federal government was pumping out meaningful stimulus.

Against that backdrop, it’s understandable that some investors think the Fed will once again jump to the rescue if, as we expect, economic growth slows through the balance of the year. We believe it’s that mindset which has interest rate futures showing a near certainty that the Fed cuts rates at least once and possibly twice by July, adding to last year’s 100 basis points (bps) of cuts.

Tempting as that view may be, we think the upcoming Fed meetings will be anything but simple, and investors should be prepared for a Fed that may take a more deliberate approach to rate setting than current pricing reflects. A slower-acting Fed may create volatility, but we believe a go-slow approach is ultimately likely to be beneficial for the economy and markets.

Stagflation nation

The problem here is that the Fed is likely to face pressure on both sides of its mandate to seek full employment consistent with price stability. If forecasts – including our own and those of several other major banks – are correct, the balance of the year will see essentially flat growth, with consumer prices rising at an annual rate approaching four percent.

The idea that the Fed will engage in “preemptive” rate cuts – which we define as lowering overnight rate targets when inflation is above three percent – is problematic, we believe, on at least three fronts:

• Cementing expectations: Central bankers tend to focus on consumers’ medium-term inflation expectations. The theory – which has support in the data – is that when folks expect inflation it becomes a self-fulfilling prophecy. Households that expect rising prices tend to spend more quickly and demand higher wages, both of which can create upward price pressure.
• Pushing on a string: It’s not clear to us how lower rates are supposed to help. If the economy is slowing because of policy uncertainty and the impact of tariffs, a 25 bps lower overnight rate is not going to do much. A little cheaper financing is great and all, but for a company with 125 percent higher input costs, the problem is much more basic: there’s insufficient demand at any profitable sales price. Rate cuts do little to change that basic math.
• Steeper curves: Although the Fed targets the rate for overnight loans, very little real economic activity is funded with daily borrowing. Corporate investments typically look to 10-year bond yields as they calculate the costs and potential profitability of a project. A preemptive central bank rate cut could raise concerns that the Fed is not giving sufficient weight to its inflation mandate, and cause investors to demand higher long-term yields. If that happens, we will likely see investment choked off, adding to growth and employment concerns.

Bottom line, we see several risks – and potentially limited benefits – for the Fed to aggressively cut rates while inflation and inflation expectations are elevated.

Policy stability

Another difficulty for the Fed in making policy based on where the economy is going is that critical inputs are changing with nearly unprecedented speed. We believe tariffs are the obvious example, with potentially game-changing levels of so-called reciprocal tariffs currently on pause. The growth impulse of the U.S. looks very different if the delay resolves with negotiated trade deals than if most of the so-called reciprocal tariffs are eventually implemented.

This uncertainty raises a major difficulty for the Fed. If it moves to cut rates ahead of the data based on high tariffs, it could find the rationale for that cut obviated by a subsequent policy move. Taken to the extreme, this could lead the Fed from a rate cut to rate hikes in very short order, potentially within one or two meetings.

The Fed’s ultimate institutional goal is to provide confidence both in the overall economy and in the value of the dollar. Rapid shifts in policy aren’t conducive to confidence building, and we think the central bank will prefer to wait and be sure versus moving quickly based on the shifting sands of fiscal policy.

Slowly at first, then all at once?

We see two likely paths for the Fed to move rates lower.

The first is a drop in inflation expectations that gives the Fed both comfort and a strong policy argument for lower rates, even if the latest inflation numbers are above target. The actual trigger levels for action will depend on the interplay of unemployment, leading economic growth indicators, current inflation, and inflation expectations – we’re definitely in the realm of chess, not checkers – but we think contained inflation expectations are a prerequisite for early action.

The second route would likely be holding off until slower growth and rising unemployment both contain inflation and force the Fed into action. In this case, we would expect the slow start to be matched by more aggressive action, with the Fed willing to entertain larger moves, much as it did during last year’s cutting cycle.

For investors, we see a risk that a Fed that fails to cut as quickly as expected could be perceived as markets losing a pillar of support, potentially creating short-term volatility. We think that view underestimates the challenges facing the central bank and believe a focus on inflation and inflation expectations is likely to be more effective path in the long run.