As expected, the Fed opted to hold interest rates steady for the fourth consecutive meeting in a range of 4.25% to 4.50%. The latest Summary of Economic Projections (SEP) shows an expectation for higher inflation and slower growth, resulting in no change to the median forecast for policy (median fed funds projected at the end of this year did not change).
The median continues to look for two cuts this year, but a remarkable 7 of 19 FOMC participants are calling for no cuts this year, which is almost as many as the eight calling for two cuts. Two expect just one, while the remaining two expect three. The median last September was for four cuts this year. On net, the Committee still anticipates two rate reductions by year-end, although the forecasts were again compressed towards the hawkish end of the spectrum.
The FOMC as a whole sees higher inflation this year, remaining a little higher through 2027. The median dots reflect this fear, showing one fewer cut by the end of 2026 holding through 2027. The longer-run dots did not move at all.
Note, core inflation is currently 2.5% year-on-year, but the median forecast for 2025 is now 3.1%. The forecast implies a remarkable pickup in inflation in the second half. Next year, the Committee expects 2.4% headline and core inflation, an increase from 2.2% previously. Additionally, policy makers now see 2.1% inflation in 2027, a slight uptick from 2.0% forecasted in March. The growth outlook, meanwhile, was revised down from 1.7% to 1.4% in 2025, and from 1.8% to 1.6% next year. Their unemployment rate forecast was little changed at 4.5% for 2025 (revised up from 4.4%) and 4.5% for 2026 (revised up from 4.3%).
The Fed does not want to move pre-emptively given how fluid the U.S. economic situation is. Pausing for longer buys additional time to see the effects of recent shocks (i.e., tariffs, geopolitics). With inflation likely to pick up over the summer (energy prices & core inflation), the next opportunity to cut rates could be in Q4. More on this below.
Still Some Work but There’s Inflation Progress
Inflation typically lags the economy by about a year, but, at present, the economy’s zigs and zags impact prices with a shorter lag because it is occurring with full employment. As such, key CPI indexes wax and wane with the flight path of private payroll growth.
Employment has been slowing, and, with a slight lag, inflation is following.
Services Inflation Still Too High
The last inflation print was what we’d consider a “Goldilocks” print, with headline and core CPI and PPI coming in at 0.1%. This was lower than expectations, with little sign of tariff pass-throughs yet. The Fed will be concerned with the true impact that will likely become apparent over the next few months, after the pre-tariff surge of imports is worked through. Year-over-year core CPI ex-shelter was 1.9%, where it has largely been for two years now. Durable and non-durable goods CPI is roughly 0% y/y (normal), while services CPI ex-shelter of 3.5% is still ~50-100 bps above “normal”.
The graphic below does a good job of breaking down the components and shows how Service inflation (ex-shelter) is still moderately higher than levels typically associated with 2% inflation.
Inflation Comps: A Little Concerning
The chart below shows the month-over-month changes in headline CPI. The red bars highlight the year-ago numbers that will be rolled off of the year-over-year calculations in the coming months.
In the case of the headline CPI, month-over-month growth was 0%, 0%, and 0.1% in May, June, and July 2024, respectively. That is a low bar to surpass, which is why year-over-year inflation could easily rise over the next few months. The numbers for core inflation look similar, with low comps for May, June, and July 2024. This explains the Fed’s outlook for higher inflation for the back half of 2025, with headline CPI further magnified by higher oil prices.
Fiscal Dominance
Over the past 12 months, roughly half of all fixed income issuance that has come to the market has been Treasuries. More dollars are going to finance the government rather than productive debt to the private sector.
This is something we’ve harped on consistently. Is the public sector (gov’t) crowding out the private sector when it comes to debt issuance and the need to find buyers for our debt? Are banks coming to the rescue with capital and regulatory relief? We do find the timing for SLR relief interesting (and likely not coincidental).
The Supplementary Leverage Ratio (SLR) is a regulatory measure established under Basel III reforms that requires large banks to maintain a minimum ratio of Tier 1 capital to their total leverage exposure. As of now, the SLR is an unweighted ratio (i.e., it doesn’t adjust for the riskiness of assets) that disfavors risk-free, low margin activities like UST market intermediation. It has become increasingly binding on banks.
By exempting Treasuries from the SLR calculation, potentially via unilateral decision by the Fed, banks will be more willing to expand their balance sheets and take on Treasuries without worrying about incurring capital costs (violation of SLR creates restrictions on distributions and bonuses for bank executives). We see this policy adaptation as a way for banks to provide an additional source of Treasury demand.
Can the Fed Win?
Assuming the Fed remains in an (eventual) rate cutting cycle, how low will the fed funds rate go (i.e., where is neutral?). We still believe a ~1% real (inflation-adjusted) rate should be a good longer-term target, if the U.S. economy avoids recession. This equates to roughly a ~3% funds rate, in line with longer run projections.
Many have called for a resumption in the cutting cycle (none more vocal than President Trump). We must take a step back and think like a central banker. They made the transitory argument after COVID which in hindsight was a foolish call. This has been further amplified by inflation above their target ever since. Another spike in the CPI could mean the Fed has missed its target for half a decade (perhaps intentionally?).
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