Bank of America Merrill Lynch: Under the risk of stagflation, the Federal Reserve is unlikely to cut interest rates, but if it does, it would have to be a significant cut

The U.S. economic growth and inflation data are contradictory, the risk of stagflation adds uncertainty to the Federal Reserve's policy outlook.

According to the latest report from Bank of America Merrill Lynch, the U.S. economy is at a delicate balance point: on one hand, it faces weak consumer spending, declining business confidence, and the impact of tariff policies; on the other hand, there are rising concerns about inflationary pressures.

This stagflation risk is reshaping market expectations for the Federal Reserve's policy path—not lowering interest rates may still be the most likely outcome, but the risk of significant rate cuts has increased.

Bank of America economist Aditya Bhave stated:

This stagflation pressure means that the Federal Reserve's policy outlook is polarized: if rates are not cut, they will remain relatively high; if a rate cut is decided, it may be significantly reduced below neutral levels.

Mixed data raises market concerns of overreaction

In the past two weeks, the market has been unsettled by a series of disturbing news.

In February, several soft indicators reflecting market sentiment deteriorated.

• The University of Michigan Consumer Sentiment Index and the Conference Board Consumer Confidence Index both fell short of expectations.
• Although the manufacturing ISM index barely held above 50, the new orders and employment sub-indices saw a significant decline.
• The preliminary value of the S&P Services PMI even dropped below the 50 threshold.

However, Bank of America Merrill Lynch believes that the market's concerns about these soft data may be somewhat excessive. First, there is a disconnect between market sentiment and actual economic activity. In 2023-24, despite low consumer confidence and the manufacturing ISM index being in a contraction range for almost the entire time, the U.S. economy still achieved nearly 3% growth.

Secondly, not all soft data is performing poorly, especially in the services sector, which accounts for about 46% of GDP and 84% of employment. The ISM Services Index exceeded expectations, and the final value of the S&P Services PMI also returned above 50.

In addition to the weakening of soft data, the "cliff-like" drop in the Atlanta Fed's GDPNow model for U.S. GDP growth in the first quarter has also triggered market panic.

Bank of America Merrill Lynch pointed out that the significant drop in the GDPNow model is mainly due to its "incorrect" handling of import data and an overly pessimistic interpretation of the details of the manufacturing ISM index. In fact, the ISM index should not affect GDP data at all. Considering the weak consumer spending in January, Bank of America Merrill Lynch currently tracks the U.S. first-quarter GDP growth rate at 1.9%, while the GDPNow forecast is -2.4%

Of course, some hard data has also shown signs of softening at the beginning of the year, including consumer spending and construction activity. Some of the weakness may be attributed to weather factors. However, considering that uncertainty shocks may be intensifying, Bank of America Merrill Lynch is closely monitoring changes in "soft and hard" data.

Even if the Federal Reserve cuts interest rates, it won't be a small cut

Even though the market's reaction to soft data and the GDPNow model may be somewhat excessive, Bank of America Merrill Lynch believes that the downside risk to U.S. economic growth has clearly increased. At the same time, the upside risk of inflation is also rising. This puts the Federal Reserve in a dilemma, as it needs to balance between the two major goals of "full employment" and "price stability."

Bank of America Merrill Lynch's baseline forecast is that the Federal Reserve will keep interest rates unchanged. However, market expectations for the magnitude of the Federal Reserve's rate cuts have risen from about 25 basis points after the January CPI data was released to the current approximately 70 basis points.

Bank of America Merrill Lynch believes that the most likely trigger for a Federal Reserve rate cut is a rapid rise in the unemployment rate.

If the unemployment rate rises to 4.3% in April, the Federal Reserve may cut rates in May. If the unemployment rate further rises to above 4.5%, even if the increase is gradual, it may trigger a rate cut.

Of course, these scenarios assume that overall and core PCE inflation remains below 3%. If inflation exceeds 3%, the Federal Reserve will face a more difficult choice.

In addition to this factor, Bank of America Merrill Lynch believes that if the three-month moving average of non-farm payroll additions quickly falls below 100,000, or if there is a risk of an economic recession in the U.S., the Federal Reserve will cut rates.

If the labor market collapses under inflationary pressure, the Federal Reserve may not just cut rates to neutral levels.

In the event of recessionary panic without an actual recession, the Federal Reserve may lower rates to 2-2.5%;

If a recession does occur, the Federal Reserve may lower rates to 1% or even lower