CICC: The Federal Reserve's "Dilemma"

At the FOMC meeting in May, which concluded early this morning Beijing time, the Federal Reserve held steady as expected, maintaining the benchmark interest rate at 4.25% to 4.5%. Prior to the meeting, the market consensus was that the Federal Reserve would continue to adopt a wait-and-see approach, with the implied probability of no rate cut in May from CME interest rate expectations remaining above 90% since mid-April.

Therefore, the focus of this meeting was more on how the Federal Reserve would find a balance in the face of the uncertainty of tariffs and their dual impact on inflation and growth. Should it "tolerate" a one-time inflation shock to preemptively address future growth pressures, or focus on the "immediate" inflation pressures at the expense of growth? This is also Powell's "dilemma." If the Federal Reserve views the impact of tariffs more as a one-time price shock, then it still has the ability to quickly cut rates to address the risks of economic downturn; however, if tariffs push up the slope of inflation, the Federal Reserve may have to "sacrifice" short-term growth and maintain high rates for a longer period to combat inflation.

Chart: The implied probability of no rate cut in May from CME interest rate expectations remained above 90% before the meeting.

Source: CME, CICC Research Department

In terms of results, this meeting was somewhat neutral and even slightly hawkish, as Powell repeatedly emphasized the significant "uncertainty" of tariff policies and their impact on inflation and growth, needing more "hard data" for confirmation. However, it also ruled out the possibility of "preemptive action," as, aside from the uncertainty of tariffs, the current economic data is not bad, and with Powell's term ending in May next year, a wait-and-see approach may be the short-term optimal solution.

However, the market's expectations for rate cuts remain "too strong." Although the probability of a rate cut in June has quickly converged to below 50%, the implied probability of a rate cut in July from CME interest rate futures remains at 80%, with expectations of three rate cuts within the year. After the meeting's decision, U.S. stocks, bonds, and the dollar reacted little, reflecting the market's full and conflicted expectations.

Chart: After the meeting, CME interest rate futures implied a rate cut starting in July, with a total of three rate cuts within the year.

Source: CME, CICC Research Department

What information did this meeting convey? Emphasizing tariff uncertainty; ruling out preemptive rate cuts, "responding to changes without changing"

This meeting maintained the benchmark interest rate at 4.25% to 4.5%, fully in line with expectations. In his most recent appearance before the May FOMC meeting, Powell stated at the Chicago Economic Club that "despite increasing uncertainty and downside risks, the fundamentals of the U.S. economy remain solid, and we will continue to assess whether the price increases triggered by tariffs are persistent or temporary." Therefore, against the backdrop of strong non-farm payrolls in April, an unchanged unemployment rate of 4.2%, a first-quarter GDP more affected by "import grabbing," and the CPI data for April yet to be released, the consensus in the market is that the May FOMC will keep the Federal Reserve on hold.

Chart: April non-farm payrolls exceeded expectations, the unemployment rate remained unchanged at 4.2%, and wage growth has cooled compared to last month.

Source: Haver, CICC Research Department

Chart: The first-quarter GDP annualized quarter-on-quarter turned negative more due to "export grabbing."

Source: Haver, CICC Research Department

Emphasizing that the uncertainty of tariffs is huge; it affects both inflation and growth, but it is difficult to determine which has a higher priority; therefore, the best strategy is to wait and see. Powell emphasized several points in the subsequent press conference: 1) Tariffs themselves have significant uncertainty, and the progress of upcoming tariff negotiations is crucial; 2) Facing the dual impact of tariffs on inflation and growth, the inflation impact comes first but may be short-lived, while the growth impact comes later, but the Federal Reserve currently finds it challenging to determine which has a higher priority, as the inflation expectations caused by this may be more persistent. 3) Therefore, the optimal strategy now is to wait and see, keeping on hold, as it is not a good time for preemptive action. 4) As for how long to wait? Powell "vaguely" indicated that if tariffs remain at current levels, it may lead the Federal Reserve to delay achieving its goals until next year, which means it is difficult to cut interest rates within this year, but this assumption itself is too strong.

Future policy path and space? First "inflation" then "stagnation," without "inflation" there will be no "stagnation"; expecting the Federal Reserve to cut rates too quickly is unrealistic.

To understand the Federal Reserve's policy space and "difficulties," one must first understand the impact path of tariffs. For the United States, tariffs are a supply shock in the short term and may also be a demand shock in the long term. The current question is, how short is this short-term supply shock, how high will the peak of inflation be, and whether it can lead the Federal Reserve to focus more on long-term pressures beyond this pulse; this will directly depend on the progress of negotiations in the coming months.

But one thing is certain, that is, there must be "inflation" before there can be "stagnation," and without "inflation," there will be no "stagnation." If there are no inflation risks caused by the supply side, even in the face of recession pressures similar to last year's third quarter "Sam Rule," the Federal Reserve could respond quickly to growth risks. Moreover, the current growth pressure has not manifested; April non-farm payrolls remain strong, and the ISM manufacturing and services PMIs also maintain resilience, so even if the Federal Reserve wants to respond preemptively, there is not enough reason to do so If tariffs remain at this level, we estimate that an effective tax rate increase of 15 percentage points will lower the U.S. real GDP growth rate by 0.9 percentage points in 2025, pushing PCE up by 1.6 to 1.8 percentage points to 4.1 to 4.3%, corresponding to a 1 percentage point increase in CPI year-on-year, and a 1.25 percentage point increase in core CPI, bringing the level close to 4% by the end of 2025. In this case, the Federal Reserve will find it difficult to quickly cut interest rates. "How big is the impact of 'reciprocal tariffs'?"

Chart: We estimate that a 15 to 17 percentage point increase in the effective tax rate may push PCE up by 1.6 to 1.8 percentage points.

Source: Haver, CICC Research Department

Chart: We estimate that CPI will increase by 1 percentage point year-on-year, and core CPI will increase by 1.25 percentage points, with both close to around 3.6% in September 2025.

Source: Haver, CICC Research Department

The only difference is whether and how quickly the inflation pulse caused by tariffs can be offset by a decline in demand. The current market divergence lies in whether prices are temporarily rising or trending upward, and whether the extent of demand weakening is sufficient to reverse the Federal Reserve's current policy focus, which will also lead to different responses from the Federal Reserve. For example, Federal Reserve Governor Waller stated in April that he believes the timing of interest rate cuts by the Federal Reserve depends on tariff policy scenarios. A "high tariff" would lead to a severe economic slowdown, forcing the Federal Reserve to cut rates quickly, while "low tariffs" would provide the Federal Reserve with more adjustment windows, expecting to start cutting rates later in the second half of the year. However, even so, the timing of rate cuts may need to be postponed rather than advanced, especially considering that Powell's term ends in May next year, which poses a significant risk of premature reaction.

At least for now, "hard data" has not yet begun to reflect the suppression of demand caused by tariffs. The situation faced by the Federal Reserve is different from that in 2022. Although inflation was high in 2022, fiscal stimulus was still in effect, so demand resilience "supported" growth, and there was no substantial basis for a significant contraction in demand. This is also why the Federal Reserve adopted a "hawkish rate cut" in December 2022 ("December FOMC: Slowing down but not reducing quantity"). However, the current fiscal strength has weakened, and growth is indeed on a downward trend, but the important economic data released before the May FOMC has not fully reflected the weakness in demand. 1) The negative quarter-on-quarter annualized GDP in the first quarter was more due to "export grabbing," with a rough total of surging imports (dragging down by 5 percentage points) and inventory (contributing 2.25 percentage points), thus "import grabbing" dragged down by a total of 2.78 percentage points; Durable goods consumption is weakening, service consumption is stable, and corporate investment, especially in information processing equipment, has significantly improved. The capital expenditure growth rate of the information technology sector in the S&P 500's first-quarter performance has risen to 43% year-on-year; 2) In April, non-farm payrolls exceeded expectations, the unemployment rate remained unchanged at 4.2%, and wage growth rates have cooled compared to last month, which is significantly stronger than the market's concerns about "recession" and the Federal Reserve's rapid interest rate cuts.

Looking ahead, the next two months are crucial, as both U.S. growth and inflation can still "hold on for a while." On one hand, strong exports and low oil prices mean inflationary pressures are not manifesting quickly; on the other hand, consumption and investment, and even tax cuts, may keep growth pressures manageable. The progress of tariff negotiations and the potential for tax cuts are critical for the Federal Reserve's policy path in the third quarter.

Asset Implications? After the peak supply of U.S. Treasuries, there are technical opportunities for long positions, gold is overdrawn in the short term, the dollar is under pressure but the extent is limited, and U.S. stocks will look to the progress of tariff negotiations.

From the perspective of interest rate cut expectations reflected in assets, gold and the Nasdaq have priced in more easing expectations than the Federal Reserve, while U.S. Treasuries and the Dow Jones have more hawkish expectations. This also means that if the Federal Reserve can cut rates, the expected elasticity of U.S. Treasuries and the Dow Jones may be greater, and vice versa. Calculating with a 25 basis point cut as one rate cut, the current expected rate cuts over one year for assets are: gold (2.1 times) > Nasdaq (2.1 times) > Federal Reserve dot plot (2 times) > S&P 500 (1.8 times) > copper (1.7 times) > Dow Jones (1.5 times) > U.S. Treasuries (1.5 times).

Chart: From the perspective of interest rate cut expectations reflected in assets, gold and the Nasdaq have priced in more easing expectations than the Federal Reserve, while U.S. Treasuries and the Dow Jones have more hawkish expectations.

Source: Bloomberg, Federal Reserve, CICC Research Department

In the case where the Federal Reserve is unlikely to cut rates quickly, the downside space for U.S. Treasuries is limited, which is also a viewpoint we have indicated since the emergence of reciprocal tariffs ("How big will the impact of 'reciprocal tariffs' be?"). If there are no rate cuts this year, it corresponds to U.S. Treasuries at 4.2-4.5%; if there are 2-3 rate cuts, it corresponds to 4-4.2%. In the short term, U.S. Treasuries may still face a wave of peak supply, and if they rise as a result, it will provide a technical opportunity for long positions, with a reasonable level of 4.2-4.5%.

Chart: The baseline scenario still requires 2-3 rate cuts throughout the year, corresponding to a 10-year U.S. Treasury yield expectation of 3.6-3.7%, while the extreme scenario of no rate cuts corresponds to 3.8-3.9%.

Source: Haver, Federal Reserve, CICC Research Department Chart: The downward space for US Treasury yields is limited, and a rise may bring technical long opportunities

Source: Haver, CICC Research Department

The resolution of the debt ceiling may bring technical opportunities for allocating US Treasuries. Once the debt ceiling is resolved, the Treasury will replenish the previously consumed TGA account through bond issuance, which is equivalent to "withdrawing" liquidity. This may lead to a rise in term premiums due to short-term supply-demand mismatches. However, from a static perspective, the scale required for this round of bond issuance is smaller than in 2023 (current TGA gap of $138 billion vs. $500-600 billion before the resolution of the 2023 debt ceiling), and the maturities in May and June are mainly concentrated in short-term bonds, so the refinancing pressure is not significant. Although the Treasury's latest quarterly financing plan announced at the end of April was significantly revised upward ($514 billion vs. $123 billion estimated in February), it is still far below the $1.01 trillion in the last three quarters after the resolution of the 2023 debt ceiling. The main reason for the upward revision is that the cash balance level is far below the Treasury's previous expectation of $850 billion (vs. actual $406 billion). Excluding this factor, the financing plan at the end of April is still $53 billion lower than the February estimate.

Chart: The current gap is about $138 billion, smaller than the $500-600 billion before the resolution of the 2023 debt ceiling

Source: U.S. Department of the Treasury, CICC Research Department

Chart: The scale of US Treasury maturities in May and June increases but is not extreme, and mainly consists of short-term bonds

Source: Bloomberg, CICC Research Department

The US dollar is under short-term pressure but the extent is limited. Recently, the US dollar has stabilized somewhat. Our global liquidity model estimates that the US dollar may still be slightly under pressure in the short term, but the extent is limited, with support around 98. In the third and fourth quarters, it is expected to gradually recover. The long-term logic for gold remains valid, but it is overdrawn in the short term; the weak expectation for the US dollar is the main factor for the recent rise in gold. Since the end of 2024, gold has risen mainly during Asian trading hours, remained flat during European hours, and even declined during American hours. If the current levels of real interest rates and uncertainty remain unchanged, the implied dollar level of gold is basically close to the current dollar index (currently 99) Chart: We estimate that the short-term US dollar remains under pressure, but the extent is limited, and it may gradually recover in the third and fourth quarters.

Source: Haver, Bloomberg, CICC Research Department

Chart: Given that real interest rates and uncertainty remain unchanged, the current implied dollar level of gold prices is basically close to the current dollar index (currently 99).

Source: Bloomberg, CICC Research Department

US stock valuation recovery, future space depends on tariff negotiations and tax reduction progress. "Reciprocal tariffs" directly impact short-term risk premiums. We previously indicated in "How Much Impact Will 'Reciprocal Tariffs' Have?" that the Nasdaq valuation dropping to 21 times gradually becomes attractive. Recently, benefiting from economic data, tariff negotiations, and the performance of leading technology companies, it has recovered to around 25 times, consistent with our viewpoint. However, after the basic recovery, the subsequent trend will depend on tariff negotiations and tax reduction progress.

Chart: If the S&P 500 risk premium is compared to the 2022 peak of 2.7%, it corresponds to a dynamic valuation of 16 times (currently 21 times).

Source: Bloomberg, CICC Research Department

Chart: The Nasdaq index risk premium of 0.6% is closer to the 1% low valuation in 2022, corresponding to a dynamic valuation of 21 times (currently 25 times).

Source: Bloomberg, CICC Research Department

Author of this article: Liu Gang et al., Source: Kevin Strategy Research, Original Title: "CICC: The Fed's 'Dilemma'"

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