Key Highlights

• Risks to the downside for growth and the upside for prices have both increased
• If growth disappoints and short-term inflation rises due to tariffs, the Fed will prioritize the employment element of its mandate
• As long as longer-term inflation expectations remain anchored, this will allow the Fed to look through short-term price increases

Which way will the Fed turn?

EXHIBIT #1: INVERTED INFLATION EXPECTATION TERM STRUCTURE

^{Source: Source: BNY Markets, NY Fed, Bloomberg, University of Michigan, Federal Reserve Board of Governors}

If the economy slows and inflation stays elevated – or even rises – as we move deeper into the year, which side of its dual mandate will the Fed prioritize? Fedspeak since the last FOMC seems to us to be divided, with some officials emphasizing inflation and possible upside risks to already elevated levels, while Chair Powell, in his post FOMC press conference, indicated that rates could come down or stay where they are, notably avoiding any mention of potential higher rates. Our view comes down to long-term inflation expectations. If they remain anchored, even in the face of short-term price increases due to tariffs, we think the Fed would be more inclined to err on the dovish side if growth begins to disappoint.  
 
Let’s first discuss inflation. Short-term inflation expectations have indeed risen, as measured by both market- and survey-based indicators. This is entirely reasonable and intuitive. Prices will almost undoubtedly rise as tariffs are passed on by importers. Whether they are expected to continue rising beyond the short term – in other words, whether price increases become persistent inflation – would ultimately be seen in inflation expectations beyond a few years forward. In orthodox central banking, these interim price movements may not need to be confronted with tighter policy. Exhibit #1 above shows the “inverted” term structure to inflation expectations across a range of sources, ranging from consumer surveys (University of Michigan and the New York Fed), the FOMC itself (the Summary of Economic Projections) and forecasters (Bloomberg consensus). In all cases, inflation is expected to be higher in the short term, but lower in the long term. 
 
Furthermore, tighter policy would probably prove ineffective in offsetting price pressures that are ultimately due to higher taxes (in this case on imported goods) and exogenous to the inner workings of the economy. If anything, tighter policy could further weaken what would already be an economy on its backfoot due to the tariff shock.  
 
Speaking of the economy being on its backfoot, this brings us to the growth side of the Fed’s dual mandate. Sentiment indicators, both consumer and business, are weakening dramatically – especially forward-looking elements of these surveys. Hard data – that is data which actually measure activity and output – are still holding up and it’s also well-known that “soft data” do not have a perfect track record in predicting eventual outcomes. Nevertheless, the softness in risk assets, the downgrades in growth forecasts and upgrades in recession probabilities cannot be denied.

Forward look

Could we bet setting ourselves up for what is best described as the dreaded “stagflation” scenario? Higher inflation with slower growth is not unlikely in the short term. This wouldn’t be a surprise to the Fed, which in the collective wisdom of the FOMC Summary of Economic Projections, moved its expectations for growth lower, unemployment higher, and inflation higher for end-2025. Furthermore, as Exhibit #2 indicates, the risks assigned to upside or downside outcomes for these key macro variables line up with weaker growth, higher unemployment and higher inflation. At the same time, the median projection for the federal funds rate this year was steady at two cuts, matching our own view. The market now sees more than three cuts through December this year, indicating that the Fed will err on the dovish side of its dual mandate.

EXHIBIT #2: FED SEES DOWNSIDE RISK TO GROWTH, UPSIDE RISK TO UNEMPLOYMENT, INFLATION

^{Source: BNY Markets, Federal Reserve Board of Governor}

We tend to agree, although we’re reluctant to alter our current rates view until (if?) we see weaker hard data coming down the pike. More importantly, as shown in Exhibit #3, the bond market agrees, with a rally in the 10y that brought yields from around 4.8% in mid-January down to a range of 4.2%-4.4% recently. The growth outlook, and with it, the rates outlook has been declining. On the other hand, and consistent with our argument above, inflation expectations at long horizons (illustrated by the 5y5y inflation swap) have essentially flatlined. The inference from this is that short-term inflation will likely rise, but if long-term measures stay put, the Fed could more easily loosen policy rather than keep it restrictive in the face of an economy already at some risk.

EXHIBIT #3: BOND YIELDS REFLECT CONCERNS ABOUT GROWTH AND FOMC RESPONSE

^{Source: BNY Markets, Bloomberg}