FOMC Update: Risky Business

1. The Fed delivered a dovish statement and SEP today, while Chair Jay Powell did the same with the press conference that followed. 

2. It is clear that, willingly or not, the Fed has a nonchalant attitude towards inflation. The December 2025 projection for Core PCE jumped 30bps to 2.8%, and yet the median 50bps of expected cuts remained. 

3. The justification came from a significant slowdown in growth projections (40bps in 2025 to 1.7%) alongside a shift of growth risks to the downside.

4. Though we agree with the FOMC's premise (that slower growth should slow down domestic inflation as well, while the tariff impact will be front-loaded), we are somewhat surprised at the Fed's risk tolerance toward above-target inflation and rising inflation expectations. 

5. There is a significant risk that this conditional thinking goes very wrong--and leads to another inflationary overshoot--followed by the Fed playing catchup with higher rates. 

6. For now, this remains in the distant future (i.e., the July meeting). We still expect the Fed to cut rates in June, even if it proves a mistake in the long run. 

Details below:

• In line with market expectations and communication, the Fed held rates steady today. In its statement, it removed a reference to risks to the two sides of the mandate being in balance--a change we previewed in January (see FOMC Update: Willful Ignorance). 
• However, it also sharply reduced the pace of quantitative tightening (QT), from $60BN to $40BN, with the entire reduction coming from the Treasuries roll-off rather than agency debt. Somewhat oddly, Christopher Waller, who has been a noted dove recently, voted against the QT aspect of the decision. 
• Powell noted multiple times that this was intended to be a "technical" move intended to help with the Treasury General Account (TGA) as the Treasury approaches the debt limit--rather than a monetary policy move. 
• Powell also opened the door to the Fed restarting net purchases in Treasuries to accommodate the drawdown in agency securities. This will doubtless become more important as the fiscal debate intensifies in the second half of the year. 
• On monetary policy proper, the press corps barraged Powell with the obvious question: if the Fed is already overshooting inflation and the SEP projections are revised higher (with unemployment steady), how come you are cutting rates?
• Powell provided a nuanced answer that partly relied on U.S. trade policy: the Fed is now expecting some inflation from tariffs--but it is also expecting it to be transitory and thus unlikely to affect inflation in 2026 and 2027. 
• Meanwhile, the policy mix is also proving more contractionary than expected, pushing growth and employment risks to the downside. 
• Therefore, the Fed sees little reason to counteract the inflationary aspect of tariffs with monetary policy--and remains attentive to the growth risks it might be called to weigh against. Powell again referred to the 2018 experience with increased tariffs.
• This is an elegant solution--if today's experience were anything like 2018. 
• But unlike 2018, today's tariffs are much broader and are inviting harsher retaliation from trading partners. 
• Perhaps more importantly, the recent post-COVID inflationary wave is fresh in the minds of both businesses and consumers. The risk is therefore that the inflationary shock diffuses into domestic inflation much more quickly than it did in 2018. 
• This is also what consumers are telling us, raising both their short-term and long-term inflation expectations in surveys. 
• Again, the press corps rose to the occasion, asking Powell repeatedly how the Fed can cut rates in an environment of rising consumer inflation expectations. 
• There, the chairman was less convincing. He dismissed the Michigan survey as an "outlier" and insisted that long-term expectations remain well anchored. 
• That may well be true, and there are many issues with the survey--but consumers were also much quicker than the Fed to realize how bad inflation was getting in 2021. This seems like a risky signal to ignore. 
• Finally, Powell dodged questions about the Fed's ability to remain independent, referring reporters to his previous answers on the issue. 
• This has gained new relevance given the Trump administration's multiple fights with the judiciary--as well as Trump's firing of the two Democrats on the Federal Trade Commission. 
• It is easy to understand why Powell would want to be cautious not to upset the administration--the Fed has remained relatively under the radar during the past two months. 
• But it is also impossible to escape the conclusion that perhaps the Fed's higher tolerance for inflation may also be the result of political pressure, rather than risk-adjusted macroeconomic modelling.  

All best, 

Dimitris and the Aurora team.

To book a meeting with me to discuss these or any other Aurora themes contact juliet@auroramacro.com

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