Fed Might Not Cut Rates This Year, Goldman's Kaplan Says

Key Concepts

Tariffs, supply chains, margin pressure, recession probability, fiscal policy, labor force growth, unemployment, dual mandate of the Fed, rate cuts, economic projections, Fed's reaction function, long-term rates, bond market, deficit, term premium.

Tariffs and Business Adjustments

• Impact of Tariffs: Clients are reacting to the uncertainty surrounding the Trump administration's tariff policy. Goldman Sachs believes the administration will likely find other authorizations to continue implementing tariffs. The expectation is that tariffs will settle in the low to mid-teens.
• Challenges for Businesses: Tariffs will create challenges for companies, especially small businesses that lack the leverage to adjust.
• Strategies for Larger Companies: Larger companies are reviewing their logistics and supply chains to reshift production, which could take six months to a year. They are also pressuring suppliers, absorbing some costs in their margins, and potentially increasing prices.
• Cost Management: Companies are looking to tighten their belts to offset margin compression caused by tariffs.

Recession Probability and Economic Slowdown

• Recession Probability: Goldman Sachs' chief economist, John Hatzius, reiterated a 35% probability of a recession, which is considered a material and elevated level.
• Structural Issues Mitigating Recession: Several structural issues are reducing the probability of a recession, potentially leading to sluggish growth instead.
• Fiscal Policy: The initial expectation was deficit reduction through extending the Trump tax cuts. However, fiscal policy may be more expansionary or neutral due to less cost-cutting and a more expansive tax package.
• Labor Force: Decelerating labor force growth due to changes in immigration policy means a tighter labor market, making a spike in unemployment less likely. A spike in unemployment is typically associated with severe economic downturns.
• Tariffs Impact: Tariffs tend to slow growth and raise prices.
• Overall Outlook: The expectation is for sluggish growth for the remainder of the year, rather than a recession.

The Federal Reserve and Interest Rate Policy

• Dual Mandate Concerns: Concerns exist about the Fed's dual mandate (price stability and full employment) due to potential inflation from tariffs and sluggish growth.
• Patience and Uncertainty: The advice is for the Fed to be patient due to significant uncertainty and structural changes in the economy.
• Unemployment as a Trigger: A spike in unemployment would force the Fed to take more aggressive action and potentially cut rates more significantly.
• Tariff Impact Assessment: The Fed is waiting to see how tariffs will affect the economy, with a better understanding expected by summer and fall.
• RCP Summary of Economic Projections: The Fed will submit an RCP summary of economic projections in June.
• Potential Rate Cuts: The expectation is for one to two rate cuts, with one being more likely, which is less than what the market had been expecting.
• Wait-and-See Approach: The Fed is expected to take a patient, wait-and-see approach.
• Market Expectations vs. Fed Actions: The market is pricing in two or fewer rate cuts, while some, like Morgan Stanley's Mike Wilson, anticipate up to seven rate cuts by the end of next year.
• Possibility of No Rate Cuts: There is a chance the Fed may not cut rates this year.
• Uncertainty and the Fed's Reaction Function: The Fed doesn't know what the tariff rates or the final tax bill will be, leading to uncertainty. The Fed's reaction function will be more immediate and reactive to incoming data.

Long-Term Rates and the Bond Market

• Fed's Limited Influence: The Fed has limited influence over the 10-year Treasury yield, as it primarily controls the Fed funds rate.
• Focus on the 10-Year Yield: The focus is more on the 10-year yield than the Fed funds rate due to concerns about the deficit.
• Deficit Concerns: The US entered the year with deficits close to 7% of GDP. The expectation of deficit reduction may not materialize.
• Rising Back End: The back end of the yield curve is inching up, potentially due to a rising term premium, making it harder to be a duration buyer.
• Continued Wrestling with Deficits: The expectation is that the market will continue to grapple with deficit concerns for the rest of the year.

Synthesis/Conclusion

The current economic environment is characterized by significant uncertainty due to tariffs, fiscal policy, and labor market dynamics. While a recession is not the most likely outcome, sluggish growth is expected. The Fed is likely to remain patient and data-dependent, with a limited number of rate cuts anticipated. Concerns about the deficit are driving up long-term rates, making the 10-year Treasury yield a key indicator to watch. Businesses are adjusting to tariffs by reviewing supply chains and managing margins.