Uncertain
Fed stays in wait-and-see mode, but makes major changes to its forecast
Published March 21 2025
Bottom line
The Federal Reserve remained on pause with interest rates for its second consecutive meeting on Wednesday, as we and many others had anticipated. But given heightened economic uncertainty due to President Trump’s still unfolding and unknown tariff plans, the central bank also lowered its expectations for GDP growth for this year, while increasing its estimates for inflation and the rate of unemployment.
So, the upper band of the fed funds rate remains at 4.5%. But in its new March update of its quarterly Summary of Economic Projections (SEP), the Fed sharply lowered its estimate for GDP growth this year from 2.1% to 1.7%, compared with 2.8% GDP growth in 2024. The Fed also reduced its 2026 GDP estimate from 2.0% in December to 1.8% now, and it lowered its 2027 forecast from 1.9% in December to 1.8% now.
The Fed also significantly increased its forecast for core PCE inflation in 2025 from 2.5% in December to 2.8% in its new March update, compared with actual core PCE inflation of 2.6% y/y in January 2025. It left unchanged its previous forecasts for core PCE inflation of 2.2% by year-end 2026 and the achievement of its longer-term inflation target of 2.0% in 2027.
The Fed also ticked up its 2025 forecast for unemployment (U-3) from 4.3% in December to 4.4% in their new March update, compared with the actual rate of unemployment of 4.1% in February 2025. It left unchanged its previous forecasts of 4.3% unemployment for both 2026 and 2027. Yesterday’s initial weekly jobless claims at only 223,000 for the March survey week confirms that the labor market is solid, and the Fed is not expecting a recession.
Stagflation risks rise So, the combination of slower economic growth, rising unemployment and higher levels of inflation is the textbook definition of stagflation, whose risk has risen in recent weeks, given the uncertainty of Trump’s country-by-country tariff plans, which will be announced on April 2.
We’re still firmly in the soft-landing camp, believing that Trump is using the threat of tariffs as a negotiating tool to extract more favorable trade terms and begin to reduce last year’s record $1.2 trillion balance of goods trade deficit, which cost the U.S. economy about 0.5% of GDP growth.
But some less constructive economists have elevated their odds of recession to 50%. Looking at the four-year presidential election cycle over the last century, many new presidents try to administer the bitter pill of a new fiscal-policy direction early in their first year, so that the economy has time to re-accelerate going into the midterm elections. Of the 15 recessions the U.S. economy has experienced over the past century, nine have disproportionately occurred in year one. Treasury Secretary Scott Bessent has discussed the Administration’s planned transition from a government-driven economy to one dependent on private-sector growth.
Fed stands pat on rate cuts Despite all these concerns, the Fed opted to keep its dot plot on future rate cuts unchanged in March from its December outlook. The Fed still expects two quarter-point interest rate cuts in 2025, two more cuts in 2026, and a final cut in 2027, which would reduce the fed funds rate to its longer-term terminal value of 3.0% sometime in 2027 or 2028. We here at Federated Hermes are similarly expecting two (or perhaps three) data-dependent cuts in the second half of this year.
What is driving this cautious but dovish monetary policy? The Fed believes that this year’s expected uptick in inflation is likely a “transitory” bump driven by a one-time price adjustment related to the upcoming tariff wars. At his presser on Wednesday, Chair Powell discussed taking a patient approach on policy, awaiting further clarity on the data, and looking through a temporary tariff-induced inflation spike.
Slowing QT The Fed also announced that it will slow the further reduction of its $6.8 trillion balance sheet. Starting next month, the Fed will allow $5 billion in Treasury securities to mature and roll off its balance sheet every month under quantitative tightening (QT) without reinvesting the proceeds in new Treasury securities, down from the current pace of $25 billion per month. But the Fed is keeping the cap on its mortgage-backed securities runoff unchanged at $35 billion monthly. The Fed’s plan is to eventually liquidate all its mortgage investments and hold only Treasuries.
Three-dimensional chess, anyone? Bessent has stated that Federal Reserve independence on setting monetary policy is sacrosanct, and that the Trump Administration’s focus is on bringing benchmark 10-year Treasury yields down, to help orchestrate stronger economic growth. Since Trump’s Inauguration only two months ago, yields have plunged from 4.8% to 4.2%. Gold has surged by 17% so far this year to a record $3,065 per troy ounce.
But despite his hands-off approach on the Fed to date, critics wonder if Trump is intentionally creating tariff hysteria to reduce GDP growth estimates and elevate unemployment forecasts, which could spark a series of interest rate cuts from the Fed later this year to keep the economy out of a full-blown recession.
Financial market volatility Stocks ripped on Wednesday, in a sigh-of-relief rally in the aftermath of the Fed’s policy-setting meeting. But we believe there are simply too many uncertainties over the next fortnight, leading into Trump’s April 2 tariff deadline. Consequently, the S&P 500 could successfully re-test last week’s 5,500 low, down nearly 11% from its February 19 record high.