Key Takeaways
• The Federal Reserve is widely expected to hold interest rates steady at its March meeting.
• A combination of slowing economic growth, sticky inflation, and uncertain policy outcomes from the Trump administration (especially concerning tariffs) could force central bankers to make tough decisions in the months ahead.
• If tariffs prove to be short-lived one-time price shocks, the Fed could look past them and continue cutting interest rates this year.
• Fed officials have been careful to sidestep discussions about the limitations of monetary policy when it comes to trade wars and other Trump policies.
As Federal Reserve officials meet this week against the backdrop of a stock market selloff, gloomy economic news, and a mounting trade war, the only clarity around the outlook for interest rates seems to be that no change is on the table this month.
Beyond that, Fed officials are in a difficult position. Inflation, as measured by the Fed’s preferred gauge, is currently 2.6%, excluding food and energy costs, stubbornly above the central bank’s 2% target. Risks are growing that tariffs will cause a fresh spike in prices, consumer sentiment is souring rapidly, spending is slowing, and once-small cracks in the labor market appear to be widening. With all this, new policies from the Trump administration on trade, immigration, and more are clouding the outlook.
“There are risks on the horizon,” says Roger Hallam, global head of rates at Vanguard. He believes the Fed’s likely next move is a cut toward the end of the year. However, he adds that “there is sufficient uncertainty in the macro outlook that it’s right for them to take their time to assess the economic implications of the new administration’s policies.”
Highlighting the precarious situation, on Wednesday, Bank of Canada officials offered a bold statement about the ability of central bankers to manage the impact of tariffs on an economy. “Monetary policy cannot offset the impacts of a trade war,” they said as they cut interest rates for the seventh time since last June. This candor starkly contrasts with more measured rhetoric from US Fed officials, who have been careful to sidestep any discussion of the limitations of monetary policy when it comes to how trade policies disrupt the economy.
Treasury Yield and Federal-Funds Rate
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The US Fed’s Dilemma on Interest Rates
The world looks very different than it did just a few months ago. Last year, the Fed cut interest rates by a full percentage point between September and December after a summer of soft inflation readings and a cooling-but-healthy labor market. It then left rates on hold in January after progress on inflation began to stall. The key federal-funds rate target range stands at 4.25%-4.50%.
Now, new tariffs could worsen inflationary pressures just as the economy was already slowing. “The Fed has been stuck between the proverbial rock (inflation) and a hard place (declining economic growth),” says Dominic Pappalardo, chief multi-asset strategist at Morningstar Investment Management. He believes the Fed’s actions will be “the most significant data point” for investors to watch in the immediate future.
On one hand, sticky inflation could mean central bankers are disinclined to ease policy. Over the past two years, they’ve been adamant that they will hold interest rates at restrictive levels until they have confidence that price pressures are returning to target levels. On the other hand, slowing growth and the threat of labor market damage could bolster an argument for cutting rates, which may exacerbate inflation but could stimulate the economy if a downturn is indeed on the horizon.
Some of the Fed’s thinking on the issue could be shaped by the tariff landscape, according to Strategas chief economist Don Rissmiller. If tariffs prove a one-time price increase or a short-lived event, the Fed could look past them as it brings rates slowly back down to neutral levels. “If you start to see a trade war, that becomes a repeat game where prices go up and up and up,” Rissmiller says. “That’s where you have to worry about inflation.”
In an environment in which central bankers are contending with both sticky inflation and slowing growth, “the key will be whether the Fed believes that elevated inflation will prove transitory or not,” says Hallam. Tariffs are part of that picture, but so are long-term inflation expectations and whether they remain anchored. Unanchored expectations can become self-fulfilling prophesies wherein the belief that inflation will rise fuels behavior from consumers and businesses (like raising prices or pulling back on spending) that can stoke inflation.
US Fed Attentive to Labor Market Risks
On the other side of the Fed’s dual mandate is the labor market. With last year’s small cracks in the employment picture growing, Rissmiller says it would be reasonable to infer that the Fed is looking more closely at that side of the equation. With policy rates already restrictive, leaving rates on hold would continue to put downward pressure on inflation. “The starting point matters,” Rissmiller says. “You have room to slightly lean toward the employment side of the mandate simply because the default is already addressing the inflation side.”
US Fed Emphasizes Independence Amid Political Tension
The mounting economic pressures on the Fed come with heightened political pressure. President Donald Trump has been unusually critical of the central bank and has more than once demanded lower interest rates. The Fed makes monetary policy decisions independently from the executive branch.
Front-running policies like tariffs with rate changes, or even commenting on how difficult it is to adjust to a rapidly changing outlook, is tricky for the Fed. “A lot of FOMC members really care about the institution, and if you appear political, that’s a problem for how monetary policy is conducted,” says Rissmiller, who adds that remaining “data-dependent” also helps the Fed stay out of politics.
Fed Chair Jerome Powell has been consistently tight-lipped about how the Fed is thinking about the potential impact of fiscal and trade policy changes like tariffs and immigration restrictions on policy, though those priorities could have a major impact on inflation and the labor market. Some assumptions will undoubtedly show up in new economic projections that will be released along with the Federal Open Market Committee’s interest-rate decision on Wednesday. “Powell has talked at length [about how] the FOMC is independent, and it will do what it feels is right to achieve its mandate of full employment and inflation at 2%,” says Hallam.
US Fed Positioned for Patience
Despite the swirling headlines and growing investor anxiety, analysts say the Fed is in a good position to sit tight, at least in the near term. “There’s no emergency right now,” says Rissmiller. “There’s no financial crisis. There’s no big surge in unemployment, so they have the benefit, fortunately, of waiting and seeing.”
Hallam adds: “The path of least resistance for the Fed is to remain on hold and to recognize that policy is still somewhat restrictive. They’ll be well served to be patient and gain greater confidence around where the economy is headed over the second half of this year.”
Fed officials have expressed the same view, and Powell has been adamant that the central bank will make policy decisions based on data rather than any predetermined path. “We do not need to be in a hurry, and are well-positioned to wait for greater clarity,” he said in prepared remarks last week. “Policy is not on a preset course.”
When Will the US Fed Cut Rates?
Investors appear to agree, and traders are nearly certain the Fed will continue its pause in March. The rest of the year is a different story. Against a weakening economic backdrop, bond futures markets are now pricing between three and four rate cuts by the end of 2025, compared with between one and two just a few months ago.
The odds of a cut at the May meeting have also risen to 25% from 18% a month ago, according to data from the CME FedWatch Tool.
Federal-Funds Rate Target Expectations for May 7, 2025 Meeting
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