Fed rate pause: Bank forecasts slower US growth and higher inflation

The Federal Open Market Committee (FOMC) voted on Wednesday to keep the benchmark interest rate unchanged at between 4.25% and 4.5%, as widely anticipated. However, the committee revised its economic outlook, projecting slower growth due to the impact of tariffs while forecasting higher inflation. Fed officials expect inflation (PCE) to be at 2.8% by the end of this year, up from a projection of 2.5% in December. US economic growth has been revised down to 1.7% from 2.1%.  

Despite a downgrade in the economic outlook, the Fed’s dot plot, a chart to illustrate expectations of the interest rates for the next three years from policymakers, projects two quarter-percentage-point rate cuts this year, remaining the same as in December. The Federal Reserve also announced plans to slow the pace of its balance sheet runoff from April.  

“Uncertainty around the economic outlook has increased,” policymakers stated.

“The Committee is attentive to the risks to both sides of its dual mandate,” they noted, referring to the labour market and inflation. Policymakers removed the language saying the dual mandate is roughly in balance from the previous meetings. 

“At first glance, what came out of the FOMC meeting should have been a bearish catalyst,” Kyle Rodda, a senior market analyst at Capital.com Australia, said.

“The dynamic flashes amber signals about potential stagflation, or at least a kind of stagflation-lite.”

Slower economic growth and higher inflation expectations, perfectly defining a stagflation economic cycle, are viewed as bearish for equity markets.  

US stock markets jump

Wall Street rebounded sharply on a broad-based rally following the Fed’s dovish shift, with all three benchmark indices finishing higher. The US stock markets have underperformed global peers, particularly the European and Chinese equity markets this year. Economic uncertainties and recession fears triggered sharp selloffs, with the S&P 500 posting a three-week loss streak in correction territory last week.  

The market rebound was likely a relief rally as the Fed did not signal a severe economic downturn despite concerns over President Trump’s chaotic tariffs. Fed Chair Powell said he expected the tariff-driven inflation to be “transitory” and downplayed recession risk.  

The rally was also related to a weakened US dollar, driven by a decline in US government bond yields due to the Fed’s growth downgrade.

“The Fed’s desire to continue to carefully lower rates despite a lift in inflation will have the effect of reducing real rates, something that tends to weaken a currency and boost the relative appeal of equities,” Rodda added.  

The interest-rate-sensitive two-year Treasury yield slid 7 basis points to 3.97%, and the yield on the 10-year bond fell 4 basis points to 4.24%.  The US dollar index fell from the intraday high and finished above 103, a key support level. In contrast, the German 10-year bund yield only fell by 1 basis point to 2.8%, remaining at a one-and-a-half-year high. The euro, however, weakened following a downward revision of Eurozone inflation.  

However, an equity rebound could be short-lived, despite the Fed’s reassurance.

“The 'Fed put' remains considerably weaker than over the last couple of years,” Michael Brown, a senior research analyst at Pepperstone London wrote in a note. The ‘Fed put’ is a belief that the central bank will limit the stock market’s decline beyond a certain point with accommodative monetary policy.

“That, coupled with the chaotic nature of policymaking in the Oval Office, should see cross-asset volatility remain elevated, while also leaving equity rallies as selling opportunities in the short-term,” Brown added.