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Rates Unchanged as Fed Navigates Complicated Backdrop

Policymakers remain in a bind, as they weigh resilient jobs data and moderating inflation against the looming economic threats posed by tariffs.

05/07/2025

Key Takeaways

The Fed remained on hold but pointed to higher inflation and unemployment as growing economic risks.

Meanwhile, Fed Chair Powell touted resilient growth and employment data, which are aiding the Fed’s patient approach to monetary policy.

We believe taking advantage of short-term dislocations while maintaining portfolio diversification may help manage the prevailing economic and market challenges.

Amid an increasingly uncertain economic outlook, the Federal Reserve (Fed) left the target short-term lending rate unchanged at its third-straight meeting on May 7. U.S. policy rates held steady in a range of 4.25% to 4.5%, higher than most other developed markets.

Despite recent pressures from net exports, the Fed continued to characterize economic activity as expanding “at a solid pace.” However, officials also warned that the labor market and inflation risks are mounting.

President Donald Trump’s tariff policy rollout in early April left the Fed’s monetary policy in a quandary:

  • Near-term rate cuts would help the Fed get ahead of the looming economic slowdown most policymakers expect.

  • However, easing while inflation remains above the Fed’s target and vulnerable to tariffs, and the labor market is still healthy, risks driving prices higher.

As the Fed assesses which scenario presents the greatest threat to the U.S. economy, it remains on hold and focused on incoming data. We still believe the economy is likely headed for a slowdown, perhaps even a recession, prompting the Fed to resume easing in the coming months.

In our view, this backdrop underscores the importance of maintaining broad portfolio diversification.

Why the Fed Is Adopting a Wait-and-See Approach

Even as he outlined the growing threats to inflation and employment, Fed Chair Jerome Powell said the economy “remains in solid shape.” In his May 7 news conference, he reiterated that the Fed is in no hurry to adjust monetary policy.

Powell suggested that moderating inflation, resilient growth and low unemployment give officials the luxury of time to set interest rates. At the same time, he highlighted the broad uncertainty in today’s economy.

Trump’s Policies Are Fueling Economic Uncertainty

Powell noted that the Trump administration’s policy changes surrounding trade, immigration, fiscal policy and regulation are still evolving, and their economic effects remain “highly uncertain.”

While tariffs and tariff negotiations remain top of mind, Powell emphasized that it’s too early to determine how trade policy will affect the economy.

Nevertheless, he still believes current policy rates remain modestly restrictive, giving the Fed time to gain greater clarity before adjusting rates. He noted the Fed is in a good position to act quickly when appropriate.

Fed’s Stance on Future Rate Cuts

Powell wouldn’t commit to cutting interest rates this year, but he didn’t rule it out either. He said he could see situations in which policymakers lower rates and conditions under which they wouldn’t. In our view, slowing growth will likely prompt the Fed to ease within the next few months.

Is the U.S. Economy Likely to Stall?

As Powell outlined, expectations surrounding Trump’s tariff policy, which led to unusual swings in net exports, weighed on first-quarter gross domestic product (GDP). The economy contracted slightly, mostly due to businesses stocking up on imported goods ahead of new tariffs.

Meanwhile, other GDP components, including consumer spending and business investment, remained healthy, highlighting the conflicting factors facing the Fed.

Additionally, private sector economic activity continued to expand but at a slower pace, while consumer and business confidence recently dropped to multi-year lows. The labor market has remained a bright spot, with job growth and the unemployment rate generally holding steady.

Nevertheless, we continue to believe the combination of government spending cuts and tariffs — on top of tight financial conditions — will fuel mounting economic headwinds. Whether the economy slips into recession or stalls, we think a downshift will characterize the months ahead.

Factors Driving Long-Term Economic Optimism

While we expect short-term economic pains, our longer-term outlook is more upbeat. We believe positive developments may emerge in the coming quarters, including:

  • Negotiated resolutions to the various trade wars.

  • Tax cuts and deregulation.

  • A manufacturing renaissance.

Together, we believe these influences should help rebuild consumer and business confidence and promote a rebound in growth.

Inflation Faces a Bumpy Road

Annual measures of inflation continued to ease in March, with the core Consumer Price Index (excluding food and energy prices) falling to its lowest level in four years.

Nevertheless, core inflation remained above the Fed’s 2% target. Consumer inflation fears persisted amid concerns about tariffs and global trade policies.

We still believe inflation will continue to moderate slowly. Of course, tariffs may create bumps in the road, but we expect them to smooth out over time. We believe the slowing economy will outweigh temporary pricing pressures, prompting the Fed to resume its rate-cut program, probably in the summer.

Importance of Diversification in Uncertain Times

Trump’s early-April tariff announcements and subsequent pauses triggered severe swings in stock and bond market performance. Widespread uncertainty about the Fed’s response and the longer-term course of monetary policy added to the confusion and chaos.

We believe broad portfolio diversification is appropriate for all market climates, but it may be particularly prudent during periods of heightened uncertainty and volatility.

As we witnessed in early April, staying diversified helped temper some of the significant swings in asset class performance. Moreover, that volatility generated market dislocations and highlighted value and opportunity across asset classes.

Over time, volatility will likely ease as the economy and financial markets adjust to new trade agreements and other aspects of Trump’s agenda. Until then, staying diversified across high-quality stocks to capture upside potential and high-quality bonds to foster risk management may help manage the effects of market fluctuations.

Authors
Charles Tan.
Charles Tan

Chief Investment Officer

Global Fixed Income

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