Where Will the Federal Reserve's Monetary Policy Head Under New Shocks?

Sun Changzhong (Research Fellow at Tsinghua University Global Private Equity Research Institute)

The Federal Reserve held its second monetary policy meeting of the year on March 17-18, deciding to keep the federal funds rate target range unchanged at 3.5%–3.75%. The decision was in line with expectations, but with the new shocks in the Middle East, the policy outlook, already full of uncertainties, has become even harder to gauge. By analyzing the meeting statement, economic projections, and Fed Chair Powell’s press conference, a general trend can be inferred from various factors.

All three sources share an optimistic view of the U.S. economy’s relatively steady growth. There are three changes in the meeting statement: first, regarding employment, the phrase “has shown signs of stabilization” was removed and replaced with “the unemployment rate has been relatively unchanged in recent months”; second, a new statement was added: “The development of the Middle East situation remains uncertain for the U.S. economy”; third, only one member, Mester, voted against the decision, advocating for a 25 basis point rate cut. The last time a member voted against, Waller, also supported holding rates steady this time, after previously calling for a rate cut.

Image source: Xinhua News Agency

Significant changes in economic forecasts relate to growth and inflation: the median forecast for this year’s real GDP growth was raised from 2.3% in December to 2.4%; for next year, from 2.0% to 2.3%; for 2028, from 1.9% to 2.1%; and the long-term potential growth rate was increased from 1.8% to 2.0%, indicating a more optimistic outlook for the U.S. economy. The median forecast for this year’s PCE inflation was sharply raised from 2.4% to 2.7%, and core PCE from 2.5% to 2.7%, remaining stable at 2% from 2027 onward. The median unemployment rate and baseline interest rate forecasts saw little change; the dot plot maintained one rate cut in 2026 and 2027, but the number of officials expecting no rate cuts this year increased from 4 to 7, with 7 expecting one cut. Powell revealed that 4 to 5 officials had adjusted their expectations from two rate cuts to one. The dispersion in the dot plot has narrowed, indicating less division within the Fed and a stronger consensus, with a more cautious stance on rate cuts. These changes suggest increased attention to inflation.

Powell candidly stated during the press conference that these forecasts can be ignored due to the current special uncertainties. However, among the many “unknowns” and “uncertainties,” he emphasized inflation: the process of cooling inflation has clearly slowed, with short-term inflation expectations rising again in recent weeks; tariff-related price pressures are still transmitting to core inflation; the Middle East situation has pushed up oil prices, further boosting short-term inflation, but the scope and duration remain to be seen; a significant decline in commodity inflation may not occur until mid-year. If inflation does not improve, rate cuts are unlikely. After a series of shocks, inflation has been above the 5-year target, and maintaining inflation expectations is more important. Regarding employment, Powell acknowledged that job growth remains low and the labor market is fragile, but he also pointed out that February’s employment data was affected by strikes, weather, and other factors, and “many indicators show some stability in the labor market.” As for the current rate level, Powell indicated it is at a critical or “higher end of the neutral rate” zone, and maintaining a “slightly restrictive” stance or near that level is important given the current dilemma.

Recent economic data support this view. On inflation, despite CPI data slowing for several months, the PCE price index used by the Fed remains high: January’s PCE rose 2.8% year-over-year, and core PCE rose 3.1%, the highest since March 2024. Based on CPI and other data, the Fed estimates that February’s PCE was still 2.8% YoY, with core PCE at 3.0%. This aligns with the pattern over the past three years, where inflation in the first two months tends to be stubborn or rebound, but this year, aside from weather and other factors, there is a special factor: tariffs. Powell explained that about 0.5 to 0.75 percentage points of the 3% core PCE come from tariffs, and the Fed is monitoring when this tariff-driven inflation will subside, likely around mid-year. However, this estimate was made before the latest conflicts in the Middle East, which could delay the timeline further and push back rate cuts accordingly.

Regarding employment, after a sharp improvement in January, non-farm payrolls in February decreased significantly by 92,000, mainly due to one-off factors such as extreme weather and 30,000 healthcare strikes, with January’s large gain representing a natural correction. Importantly, the unemployment rate remained stable, with Powell noting “little change since September last year.” Additionally, the broader U-6 unemployment rate in February was 7.9%, down 0.2 percentage points from January; the number of part-time workers for economic reasons decreased by 477,000, indicating improved job quality. Job openings in January increased, while hiring and resignation rates remained steady (3.3% and 2.0%, respectively), and layoffs fell slightly to 1.0%. Unemployment benefit claims also showed little change, suggesting the labor market remains generally stable, at least without deterioration.

As for the next steps, it depends on the duration of the Middle East conflict: if it ends soon and oil transportation normalizes, the economic impact will be limited, and the Fed might cut rates once in the second half of the year; if it persists longer, the impact could be more severe, making rate cuts unlikely, and persistent or rebounding inflation could even prompt rate hikes. The Fed has mentioned this possibility in its last two meetings. Although most participants do not see this as the baseline scenario, the signal itself is noteworthy—rate hikes are back on the table. Judging from various factors, the Middle East conflict is unlikely to last long, and the overall situation is expected to remain manageable. Nonetheless, due to productivity gains and investments related to AI possibly pushing the natural rate higher, and after six rate cuts totaling 1.75 percentage points in 2024 and 2025, current rates are close to the natural rate. The threshold for further rate cuts is rising, and room for easing is shrinking, making this rate hike cycle potentially nearing its end.