Wall Street interprets the Federal Reserve's decision: dovish highlights and mini "Powell put options"

Wall Street believes that the "stagflation" color presented in the Federal Reserve's SEP, along with Powell's judgment that the tariff impact is temporary, is a dovish signal. Additionally, Powell's dismissive attitude towards the University of Michigan's inflation expectations is interpreted as a mini put option.

On March 19, as the market expected, the Federal Reserve kept interest rates unchanged in the range of 4.25%-4.50%, marking the second consecutive time it held steady. The updated dot plot indicates two expected rate cuts before the end of the year, but there is significant divergence in predictions within the committee, which is more hawkish compared to the December forecast.

However, the market still sensed a "dovish flavor" from the Federal Reserve's SEP and Powell's speech, leading to a rebound in U.S. stocks overnight, marking the best performance on a Federal Reserve decision day since 2022.

"Powell's Put Option"

According to Goldman Sachs, the most striking change in the Federal Reserve's economic forecast is the "stagflation characteristics," primarily reflected in the significant downward revision of the 2025 real GDP forecast to 1.7%, down from 2.1%, and the 2026 forecast to 1.8%, down from 2.0%, while the inflation forecast has been revised upward, with the 2025 core PCE raised to 2.8%, up from 2.5%.

UBS stated that this is dovish because it implies that "the Federal Reserve believes tariffs may be a one-time shock to inflation." The bank also warned that a GDP below trend still leading to rising inflation is "not good news for any economy." The median forecast also indicates that the U.S. unemployment rate will rise to 4.4% in 2025, which Goldman Sachs refers to as the "tariff effect."

In contrast, Powell's press conference was more dovish.

Powell linked inflation expectations based on surveys to changes in trade, immigration, and fiscal policy, reiterating that there is no rush to adjust interest rates. When asked whether he would ignore "one-time shocks," Powell stated that he would do so as long as long-term expectations remain stable.

A highlight of the press conference was Powell's strong denial of the University of Michigan's inflation expectations survey, which is seen as a key driver of market optimism.

Data released last week showed that the preliminary one-year inflation expectation for March from the University of Michigan was 4.9%, the highest level since 2022, while the preliminary five-year inflation expectation was 3.9%, the highest since 1993. Notably, the divergence between the two parties regarding inflation expectations has reached a historical high.

Powell stated that long-term inflation expectations are stable, specifically mentioning the New York Fed's inflation expectations survey and the 5-year, 5-year forward inflation rate, while dismissing the "outlier" in the University of Michigan survey.

In response to targeted follow-up questions regarding the University of Michigan inflation survey, Powell made it clear that he would not give high weight to that survey because it is an outlier.

Powell also stated, "The slowdown in economic growth may offset inflation related to tariffs."

UBS summarized the overall message from the Federal Reserve as "declining yields, rising stocks: perhaps a glimpse of the shadow of the Fed's put option." While not exactly the "Fed put" that the market expected, the Fed's actions are more dovish than the market anticipated.

Goldman Sachs pointed out that the market seems to have found a reason to rebound (at least temporarily), with Powell's comments hitting the "right notes": "The University of Michigan inflation expectations are an outlier, hard data remains quite solid, and the risk of recession is increasing but still not high."

Analysts believe that Powell's denial of the University of Michigan data may be the biggest reason for the OIS market pricing in a 64 basis point rate cut by the Fed for 2025 at the end of the press conference, which is an increase of 10 basis points from when the Fed's statement was released.