Key Highlights

• No rate move expected Wednesday; uncertainty to be cited for lack of forward guidance
• Long-horizon inflation expectations have barely budged; near-term expectations are more problematic
• We remove one rate cut from our outlook for the year due to uncertainty

View chart pack

More questions than answers

EXHIBIT #1:  NOTABLE REPRICING OF THE FED SINCE THE CONFLICT STARTED

_{Source: BNY Markets, Bloomberg} 

The FOMC meets this week amid rising uncertainty, higher inflation expectations driven by the conflict in the Middle East, and a labor market showing signs of weakness. Even before the U.S. and Israel’s war with Iran started, we weren’t expecting any policy changes at this meeting, and we certainly don’t expect any move now. Nor do we think we’ll receive any meaningful forward guidance at the meeting or the Chair’s press conference afterward. Even though a new quarterly set of dots via the Summary of Economic Projections (SEP) will be published, we don’t think there will be much guidance to take from this exercise either.

The Fed entered its media blackout on Friday, February 27, literally the day before hostilities broke out. Since then, we have had no communications from the central bank, leaving Wednesday as the first time we’ll learn of its thinking since the war started. We frankly don’t expect to glean much – there are simply few concrete conclusions to draw at the moment.

Before the blackout, the general message we took from Fed speakers was that rates were to stay on hold for some time. With the oil shock, this stance is cemented for the time being. Exhibit #1 shows that as of February 27, rate expectations had a couple of cuts priced into the curve for year end. Indeed, at the time, December 2026 fed futures saw 61bp of easing. Currently the curve prices in only 25bp, or just one cut.

We don’t know how long energy prices will stay elevated, nor how high they could reach, so it’s nearly impossible to quantify the size of the supply shock (via oil prices) or the demand shock (via real incomes). Is the Fed more informed on these questions than the markets? More likely it will highlight the uncertainty resulting from the war and avoid being overly prescriptive about the rate path.

EXHIBIT #2: INCREASE IN INFLATION EXPECTATIONS MOSTLY IN THE NEAR TERM

_{Source: BNY Markets, Bloomberg}

With inflation already sticky, which serves as justification for holding rates, the Middle Eastern conflict only adds to this concern. So far, the increase in inflation expectations – key for the Fed to stay anchored – has been limited to the near-term. While long-term inflation expectations have ticked slightly higher in the last two weeks, they remain well within the range exhibited since the end of the 2022 to 2023 inflationary episode, as seen in Exhibit #2. The relative stability of inflation expectations will be cited as a positive development, but the Fed will insist that it’s crucial to keep them this way, while acknowledging upside risks to prices and downside risks to labor markets.

As mentioned above, the March FOMC will include the release of a new SEP, but given the uncertainty and rising risks to the Fed’s two goals, we expect that the dots will be significantly different from the previous two SEP releases. Both showed only one cut in 2026 and a little over one additional reduction in 2027. It’s possible that the projections for growth, unemployment, and inflation will be changed to reflect the shocks stemming from the conflict, but we don’t think any such changes would receive much attention.

EXHIBIT #3: FUNDING STRAINS NOT EVIDENT

_{Source: BNY Markets, Bloomberg}

We don’t expect much on balance sheet policy either. The Fed initiated reserve management purchases (RMPs) in December and has been pursuing them to the tune of $40bn per month. During periods of high demand for reserves last fall, mainly around month ends, funding rates backed up, as reserves declined from an abundant to merely ample state. These RMPs, while encouraging more active use of the Fed’s standing repurchases program (SRP), helped stabilize funding rates this year, even though some tightness occurred on days with large UST settlements. Exhibit #3 shows the relative stability of spreads since December.

The bottom line is that we expect an uneventful Fed meeting, one that yields more questions than answers. The fog of war has generated great uncertainty around inflation and the demand-side impact of the shock. The Fed is not in a position to take a definitive view and will likely offer very little in terms of forward guidance.

Rates outlook

We turn now to our longer-horizon rates outlook, acknowledging that uncertainty has rarely been higher, with the central bank’s two objectives at risk.

Before the war started, we held to a view that the Fed would cut rates three times this year – or one more than the market had expected – due to a weakening labor market. Fears of a weaker employment picture have certainly been exacerbated by recent events, but the inflation side of the current landscape gives us pause.

If the conflict settles down before the summer and oil prices can retreat, even if not to pre-war levels, we could see a return to our previous dovish view. However, we have no visibility on the course of events, the overall impact on oil, or – by extension – the trajectory of inflation expectations and U.S. demand. Reflecting this caution, we are revising our outlook and now call for two cuts this year, beginning sometime in Q3. 

Chart pack