Institutional Interpretation: The Federal Reserve waits for the storm of uncertainty, with the next rate cut possibly in the third quarter

The FOMC meeting this time is the first since Trump announced a series of tariff measures, and the market is highly concerned about how the Federal Reserve views the impact of tariffs and how monetary policy will respond. Although the monetary policy statement did not release much information, decision-makers expressed a cautious outlook on the future economy through economic forecasts and the dot plot.

The Federal Reserve predicts a certain risk of "stagflation" in the future[Figure 2]. Officials have lowered the economic growth forecast, reducing the actual GDP growth rate for Q4 2025 from 2.1% to 1.7%, and raising the unemployment rate from 4.3% to 4.4%. At the same time, inflation forecasts have been raised, with the core PCE inflation rate for Q4 increased from 2.5% to 2.8%, and the total PCE inflation rate from 2.5% to 2.7%. These changes reflect officials' belief that tariff policies will have a negative impact on the economy while increasing price pressures. Notably, the downward revision of economic growth is 40 basis points, which is greater than the upward revision of inflation by 20 basis points. This indicates that decision-makers believe the risk of "stagflation" may be greater than the risk of "inflation."

The dot plot is somewhat "hawkish," but Powell actively reassures the market. The dot plot shows that the median for rate cuts in 2025 remains at two, but the number of officials supporting fewer cuts (one or no cuts) has increased, indicating some officials lack confidence in future inflation developments. However, Federal Reserve Chairman Powell leaned towards the view that inflation pressures are temporary during the press conference, suggesting that no drastic actions will be taken. Although consumer inflation expectations from the University of Michigan rose in February, Powell believes a comprehensive examination of broad inflation expectation indicators is necessary. He specifically mentioned the 5y5y forward inflation expectations and pointed out that this indicator has not risen significantly, showing that the market still has confidence in long-term inflation. Powell also emphasized uncertainty multiple times, stating that the impact of tariffs and government spending cuts is currently difficult to assess, and the Federal Reserve will not rush to take action before data is released.

The balance sheet reduction will soon slow down to avoid repeating the mistakes of 2019. The Federal Reserve announced that starting April 1, it will slow down the balance sheet reduction, lowering the monthly reduction cap for U.S. Treasury bonds from $25 billion to $5 billion, while the reduction cap for MBS remains unchanged. This is a technical adjustment and aligns with market expectations, as several officials had already suggested in the January FOMC meeting minutes that due to the debt ceiling issue, which could cause significant fluctuations in reserves, it is reasonable to appropriately adjust the pace of balance sheet reduction before this issue is resolved[Figure 3]. The Federal Reserve hopes to avoid liquidity shocks caused by too rapid balance sheet reduction, as seen in October 2019, and thus chooses to slow down in advance. However, Governor Waller opposed the slowdown in the balance sheet reduction during the vote, indicating differing views within the Federal Reserve on liquidity management.

The market performed positively under Powell's reassurance. The U.S. stock market rose after the interest rate decision was announced, and U.S. Treasury yields fell, reflecting a slight easing of short-term market sentiment. However, we believe that uncertainty in U.S. policy has not yet dissipated, and the risks of economic downturn remain significant. On one hand, the uncertainty of tariff policies may lead businesses and consumers to wait and see, thereby delaying investment and consumption, which could slow down economic activity. On the other hand, the negative impact of government layoffs on the labor market may further manifest in the coming months, potentially suppressing consumer confidence and spending, dragging down economic growthWe believe that inflation risks mainly come from tariffs, rather than the labor market and the real estate market. Recently, the University of Michigan's consumer inflation expectations have risen, primarily reflecting consumers' concerns about tariffs. In the last two months' CPI reports, some core commodity prices have indeed increased. However, as government layoffs weaken the labor market and high interest rates suppress real estate demand, we believe that service inflation may struggle to rise, with both factors offsetting each other. Therefore, U.S. inflation is unlikely to rise significantly, and the Federal Reserve will not overreact due to sticky inflation.

We maintain our previous judgment that the Federal Reserve may still cut interest rates this year, with the next rate cut possibly in the third quarter. Given that the Trump administration has announced more tariff measures, including "reciprocal tariffs," to be implemented on April 2, we believe that the Federal Reserve will need at least two months to assess the impact of these tariffs. Therefore, unless economic conditions are extremely weak, it will be difficult for the Federal Reserve to make a rate cut decision before June. However, if the impact of tariffs on inflation is manageable and the economy continues to slow, a rate cut by the Federal Reserve in the third quarter remains possible.

Chart 1: Federal Reserve's March Interest Rate Dot Plot

Source: Federal Reserve, CICC Research Department

Chart 2: Federal Reserve's Economic Indicator Forecast (March 2025)

Source: Federal Reserve, CICC Research Department

Chart 3: Comparison of Federal Reserve Monetary Policy Statements (March 2025 vs. January 2025)

Source: Federal Reserve, CICC Research Department

Source: CICC Insights