Will the Fed Cut Rates This Year?

Key Concepts

• Stagflation: An economic condition characterized by slow economic growth (GDP deceleration) and relatively high unemployment, accompanied by rising inflation.
• Supply-Side Shock: An event that suddenly changes the price of a commodity or service, shifting the aggregate supply curve and forcing the Federal Reserve to balance conflicting mandates (inflation vs. employment).
• Dual Mandate: The Federal Reserve’s responsibility to promote maximum employment and stable prices.
• Federal Funds Rate: The interest rate at which depository institutions lend reserve balances to other depository institutions overnight; the primary tool for Fed monetary policy.
• Monetary Policy Hawk: A policymaker who favors higher interest rates and tighter monetary policy to keep inflation in check.
• Quantitative Easing (QE): A form of monetary policy where a central bank purchases securities to increase the money supply and encourage lending and investment.

---

1. The Federal Reserve’s "Wait and See" Approach

Preston Caldwell, Senior US Economist at Morningstar Investment Management, explains that the Federal Reserve (Fed) has adopted a "wait and see" stance due to significant uncertainty surrounding the economic impacts of the war in Iran.

• Forward Guidance: The Fed is currently providing virtually no forward guidance. Unlike in 2022, when the Fed committed to a clear path of rate hikes, current policy is reactive to external events outside their control.
• Market Expectations: Market sentiment regarding rate cuts has shifted significantly. In January, the market priced in two rate cuts for 2026; this has since been pared down to one, with expectations trending toward zero cuts as the consensus view.

2. The Debate on Stagflation

Caldwell addresses the growing concern regarding stagflation, noting that while the term is "fuzzy," it generally describes a regime of higher-than-normal inflation and weaker-than-normal GDP growth.

• Comparison to the 1970s: Caldwell agrees with Fed Chair Jerome Powell that comparing current conditions to the 1970s is hyperbolic.
  • 1970s Context: Unemployment reached 6–8% while inflation hit 8–10%.
  • Current Context: The economy is experiencing a mild deceleration in GDP growth, with unemployment unlikely to exceed 5% and inflation projected in the 3–4% range.
• The "Double Whammy": While the current situation is a "double whammy" (weakening jobs and rising inflation), the magnitude is significantly smaller than the historical stagflationary periods.

3. The Fed’s Policy Bind: Supply vs. Demand Shocks

Caldwell explains why supply-side shocks are more difficult for the Fed to manage than demand-side shocks:

• Demand Shocks: In events like the Great Recession or the pandemic, demand shocks push GDP and inflation in the same direction, making the Fed’s response (loosening or tightening) straightforward.
• Supply Shocks: These push the two prongs of the Fed’s dual mandate in opposite directions—weakening GDP growth while simultaneously accelerating inflation. This forces the Fed into a "bind."
• Labor Market Nuance: The labor market has weakened, but it is difficult to distinguish between "slack" (lack of demand) and natural decreases in labor supply due to reduced immigration. Despite this, Caldwell believes the Fed’s previous 75 basis point rate cuts were appropriate, but they should now "stand firm" rather than loosen further.

4. Leadership Transition and Future Policy

The discussion touched on the potential impact of a leadership change at the Fed (specifically mentioning nominee Kevin Warsh).

• Policy Philosophy: While Warsh may have made political promises to secure the nomination, his historical record is that of a "monetary policy hawk" who favors tighter policy and reduced quantitative easing.
• Institutional Reality: Caldwell argues that the change in leadership may be a "wash." Furthermore, he emphasizes that the Fed Chair is only one of 14 voters on the Federal Open Market Committee (FOMC), suggesting that individual leadership changes do not necessarily dictate a radical shift in monetary policy.

---

Synthesis and Conclusion

The primary takeaway is that the Federal Reserve is currently navigating a complex supply-side shock that limits its ability to provide forward guidance. While the economy is experiencing a "double whammy" of inflationary pressure and slowing growth, it does not mirror the severe stagflation of the 1970s. Consequently, the Fed is expected to maintain current interest rates rather than pursue further cuts, prioritizing inflation control over the downside risks to the labor market. Future leadership changes are unlikely to drastically alter this trajectory, given the committee-based nature of FOMC decision-making.