Investors have grown accustomed to the Fed intervening quickly and forcefully to support fixed assets and save the economy after the last two recessions.
They tore up that script.
The current downturn is different because it is an inflationary shock, which means that a significant amount of inflation is entering the economy at a time when inflation is already high. Low and steady inflation prevailed during the previous two recessions.
The Fed is in a difficult position right now.
Here, Powell cannot save the financial markets by himself. A 25-basis-point or 50-basis-point rate drop won’t be enough to significantly alter the course of events. SGH Macro Advisors’ Tim Duy
According to James Engelhof, chief U.S. economist at BNP Paribas Securities, the Fed does not think that rate cuts, as President Donald Trump has mandated, would counteract any downturn. The credibility of the Fed’s inflation target, which is to maintain the annual increase in consumer prices at 2%, would also be seriously jeopardized by easing.
This is due to the fact that Trump’s proposed tariff plan is a tax policy that, if implemented, will need significant structural change and result in a significant adjustment for the American economy.
Engelhof stated in an interview that the Fed is unable to change that. “That’s why it is hard to envision the Fed moving to rate cuts absent evidence of a serious economic downturn,” Egelhof stated. He went on to say that the Fed’s best course of action is to continue to have faith in its 2% inflation target.
Fed Chair Jerome Powell stated in his speech on Friday that he has no intention of lowering interest rates at the Fed’s upcoming meeting in May. Additionally, Egelhof stated that the Fed is ready to exercise patience and is unsure whether interest rate hikes or cuts will occur next.
Powell took care to eliminate any language that suggested only rate cuts. The Fed has only discussed lowering rates or maintaining policy since September. However, Friday. Powell made no indications about the Fed’s next course of action. Hikes are no longer expressly prohibited.
Fed rate cuts will be less effective in the face of the Trump administration’s tax policy, which Tim Duy, chief economist at SGH Macro Advisors, called “ill-advised.” According to Duy, the overall dynamic would not be significantly altered even if the Fed were to lower rates once or twice.
“Here, Powell cannot save the financial markets by himself. It will take a lot more than a 25-basis-point or 50-basis-point rate drop to significantly reverse the flow,” Duy wrote, in a note to clients.
Powell urged investors to understand how the U.S. central bank will manage the economic outlook in the face of both a weakening labor market and rising inflation in his speech last week.
Powell was warning markets that the Fed would resume using the Taylor Rule, which the central bank employed from the 1990s until the financial crisis, according to economists. It is a widely accepted rule of thumb showing how high the federal-funds rate would need to be to create enough unemployment to bring inflation back down to the targeted 2% level.
According to Duy, the main takeaway for investors was that, in accordance with the Taylor Rule, higher inflation readings require higher unemployment in order to maintain stable rates.
That means that, if there is a 0.5% monthly reading in the Fed’s favorite measure of inflation – the core personal consumption expenditure index, or PCE, the Taylor Rule would prescribe rate hikes unless the labor market also weakened, Duy said.
Neither Duy nor Engelof was ruling out rate cuts entirely. They agreed that the Fed might ease policy, but there would be a lot more economic pain before the cavalry arrived.
