Fed Powell (last Friday, here): “While tariffs are highly likely to generate at least a temporary rise in inflation [and slower growth, ndr], it is also possible that the effects could be more persistent. Avoiding that outcome would depend on keeping longer-term inflation expectations well anchored, on the size of the effects, and on how long it takes for them to pass through fully to prices. Our obligation is to keep longer-term inflation expectations well anchored and to make certain that a one-time increase in the price level does not become an ongoing inflation problem.” […] “It feels like we don’t need to be in a hurry”.
We are not surprised by Powell’s remarks. The Federal Reserve is in a difficult position: it cannot lower interest rates unless it becomes evident that the employment aspect of its dual mandate takes precedence—something that may not be immediately apparent. (Note: A tariff shock, in theory, contributes to higher inflation in both the short and long term; see here).
Updated baseline
We have updated the FRB-US baseline to reflect new assumptions: (i) a substantial equity premium shock equivalent to a 25% decline in the stock market, (ii) a core import price shock aligned with the announced tariffs, (iii) weaker real GDP growth in Q1 and Q2, now projected at -0.5% QoQ saar for both quarters, (iv) a one-time 10 percentage point increase in export prices, and (v) a one-time 10 percentage point depreciation of the U.S. dollar. Figure 1 presents the revised trajectories for the main macroeconomic variables.
Under the updated baseline, the model now forecasts real GDP growth to fall below 1% in 2025. Stochastic simulations estimate the probability of a U.S. recession in 2025 at 54.7%. Concurrently, the unemployment rate is projected to rise to 5.1% this year, while core PCE inflation is expected to increase markedly and remain elevated (note: what keeps inflation elevated is that at this point expectations in the model are trending higher, a really bad sign for the Fed).
Taken together, these dynamics suggest only a modest reduction in the federal funds rate in 2025, with the rate remaining near 4% this year before gradually rising again over the forecast horizon. The path of selected financial variables -including the 10y yield- implied by the new baseline can be seen here. Finally, according to stochastic simulations (available here), the probability of experiencing a recession has increased and it is now at 54.7%.
In summary, despite our best efforts to account for recent developments, the FRB-US model delivers a clear message: the Federal Reserve remains constrained. In the new baseline, an unemployment rate reaching 5% is not sufficient to warrant a rapid policy easing, as the inflation side of the dual mandate remains under significant pressure. (See below for alternative scenarios.)
Figure 1. Update FRB-US forecast
Note: Real GDP growth and core inflation are expressed on a year-over-year basis. Core inflation refers to core PCE price inflation. This forecast has been updated as outlined in the text.
Can the Fed cut quickly? Will the Fed hike?
Figures 2 and 3 present alternative scenarios. In Figure 2, we explore an outcome in which inflation rises substantially above the model’s baseline projections. In contrast, Figure 3 considers a scenario characterized by significantly weaker economic growth—effectively, a recession. The purpose of this exercise is to illustrate the contours of a potential “Fed put”: namely, what magnitude of deviation in inflation or growth would be required for the Federal Reserve to either raise or rapidly cut interest rates. In Figure 2 we assume that core PCE will reach 4% (gray lines) and 4.5% (green lines). In Figure 3 we assume that real GDP growth will remain anemic going forward: 1% (gray line) implying a recession in 2025, and 1.5% (green line).
Main takeaway: Based on the model, assuming the unemployment rate remains below 5.25%, the Federal Reserve could justify raising interest rates if the year-over-year core PCE inflation exceeds 4.5%. Conversely (see Figure 3), if inflation remains below 4% year-over-year, the Fed may pursue more aggressive rate cuts than the baseline scenario suggests—provided the unemployment rate rises above 5.25%. Although there is considerable uncertainty regarding future developments, this analysis aims to provide readers with approximate rules of thumb to guide their expectations. For the record, the path of selected financial variables (including 10y yiled) consistent with Figure 3 and 4 can be seen here and here, respectively.
Figure 2. FRB-US scenarios: Higher than expected inflation
Figure 3. FRB-US scenarios: Lower growth
Conclusion
This time is different. In our professional experience, we have not previously encountered such a pronounced tension between the two sides of the Federal Reserve’s dual mandate. The central issue, in our view, is that the Fed cannot—and will not—take decisive action until it becomes evident which side of the mandate takes precedence. This clarity may not emerge in the near term. In this context, the fact that the 10-year yield remains at or above 4% despite significant turmoil in equity markets appears, to us, consistent with the model’s estimates.