Crédit Mutuel AM: High interest rates for longer
Since the January Federal Open Market Committee (FOMC) meeting, Federal Reserve Chairman Jerome Powell and his colleagues have clearly indicated their intention to maintain a second consecutive pause on rates in March, as core inflation (Core PCE) remains above the 2% target (at 2.6% year-over-year in January; Source Bloomberg).
Additionally, inflation expectations from consumer and business confidence surveys are trending upward due to tariff hikes imposed by the Trump administration. This cautious approach from the Fed will be accompanied by an update to its summary of economic projections (SEP), which should show continued resilient growth, but fewer rate cuts this year and next in light of higher inflation prospects.
Our expectations are as follows:
- In line with investor expectations, the FOMC will unanimously keep its target rate unchanged in a range between 4.25% and 4.50%.
- Chairman Jerome Powell will reiterate that the current monetary policy of the Federal Reserve is well-positioned to fulfill its dual mandate: price stability and full employment.
- In the current environment, with heightened uncertainty due to economic reforms by the new U.S. administration (related to trade, immigration, fiscal policy and regulation), Jerome Powell will emphasize that the institution prefers to be patient regarding future rate cuts, given risks that could push prices higher.
- In this context, he will stress the need for the Fed to ensure that households and businesses continue to expect inflation to remain anchored at the 2% target to prevent inflation from becoming persistent.
- In our opinion, Jerome Powell will try to reassure financial markets by indicating:
- On the one hand, that the FOMC still believes it can reduce rates this year, as the Fed expects inflation to converge towards its 2% target in the medium term, while noting that this sometimes-bumpy process may take longer than expected.
- On the other hand, that tariff hikes could lead to a one-time increase in consumer prices, although the central bank needs more visibility in terms of scope and timing.
- The dot plot, which shows where each FOMC member thinks rates will be by year end, could, in our view, reflect a firmer message than in December 2024 by lowering the forecast from two rate cuts to only one for 2025 and 2026, with the Fed Funds target rate anticipated at 4.1% by the end of this year (up from 3.9% previously) and 3.9% by the end of 2026 (up from 3.4%). The Fed should then normalize rates to a neutral level in 2027, between 3.0% and 3.50%. In parallel, we expect the median long-term Fed Funds rate forecast, which was raised by 50 basis points since December 2023 to 3.0%, to be revised upwards again.
- Regarding the Summary of Economic Projections, despite recent mixed data, we do not expect any significant changes to GDP growth rates for 2025 and the following two years (around 2%) due to the strength of the labor market. The unemployment rate for 2025 to 2027 should remain in a narrow range between 4.2% and 4.3%. As for inflation, the "Core PCE" forecast, based on household consumption expenditures, will likely be revised upwards, especially for 2025 and 2026, to reflect upside risks to inflation that have already reflected in household inflation expectations from the University of Michigan and Conference Board surveys, as well as in business activity surveys (ISM, PMI) through the increase in prices paid by U.S. manufacturers in response to future tariff hikes. Inflation is then expected to converge to the 2% target by 2027, highlighting the 'temporary' nature of the inflation increase.
- As alluded to in the January FOMC minutes, released on February 19, the monetary committee will announce a slowdown in the pace of its Quantitative Tightening (QT) or even a pause, pending the resolution of the debt ceiling issue, which has been reinstated since January 1, 2025, at $36 trillion (Source: Bloomberg).
In conclusion, unsurprisingly, the Fed is expected to announce a pause in rate cuts in March while slowing or stopping the decline in the size of its balance sheet. The Federal Reserve will remain determined to bring inflation back to its 2% target while supporting full employment.
In the press conference, Jerome Powell will most likely reiterate that the institution must maintain a restrictive monetary policy until inflation is firmly on track to meet the 2% target. As a result, the Fed will wait for a clear assessment of the economic impact of Donald Trump's reforms before reducing its key rates to a neutral level, which is expected to be between 3.0% and 3.5%, according to estimates (Source: Bloomberg).
In this framework, the FOMC will continue to monitor economic data, evolving outlooks and the balance of risks before adjusting its monetary policy. We believe financial markets will react negatively to this monetary committee meeting, given the significant strengthening of their expectations regarding future rate cuts by the Fed since mid-February. On the bond market, the U.S. yield curve is expected to flatten.