By Jamie McGeever
ORLANDO, Florida (Reuters) – TRADING DAY
Parsing the Fed’s new economic projections and ‘dot plot’
Wall Street rallied sharply and Treasury yields fell on Wednesday as investors bet that the Federal Reserve will look through rising price pressures and continue cutting interest rates this year, after new projections showed that officials now expect lower growth and higher inflation.
While the median projection of two more rate cuts this year is still policymakers’ base case, the underlying ‘dot plot’ forecasts shifted up closer towards only one. But not quite.
Investors ignored that, however. They also ignored the growing “stagflation” risks and officials’ admission that uncertainty is elevated. Instead, they seized on Chair Jerome Powell’s belief that tariff-driven inflation will be “transitory” and largely confined to this year.
I will dig deeper into the confusing signals sent by various measures of inflation expectations below. But first, here are the scores on the doors from Wednesday’s trading around the world.
Today’s Key Market Moves.
The Fed’s decision to leave rates unchanged was widely expected. This left investors to take their cue from other aspects of what turned out to be a remarkable day that included: significant changes in the economic forecasts, underlying shifts in the “dot plot,” Powell’s resurrection of “transitory” to describe inflation, and the Fed saying it will slow the ongoing drawdown of its balance sheet.
Before all that, Wall Street’s big three indices were up between 0.3% and 0.6%, the dollar was up across the board and Treasury yields were up as much as 5 basis points across the curve.
Much of that was paring back the previous day’s moves that were marked by a widespread risk aversion among investors although, interestingly, gold didn’t pull back and held onto the $3,000 an ounce area.
But investors took Powell’s stance to be extremely “dovish,” and stocks leaped even higher, yields tumbled, the dollar cooled and gold marched on.
It will be fascinating to see if markets reverse course on Thursday. There’s certainly a case to make, given that both the growth and inflation outlooks deteriorated – stagflation is rarely a bullish environment for risk assets.
What’s more, relying on inflation being “transitory” hasn’t always worked out well.
Earlier on Wednesday, the Bank of Japan kept rates on hold as expected and, on balance, signaled that it will proceed cautiously on policy tightening due to heightened global economic and tariff uncertainty even though Governor Kazuo Ueda also said rising food costs and strong wage growth could push up inflation.
Traders slightly trimmed their rate hike bets, and now put a very slim chance on the next move – and only hike this year – coming in October rather than September.
On the geopolitical front, U.S. President Donald Trump and Ukrainian President Volodymyr Zelenskiy agreed on Wednesday to work together to end Russia’s war with Ukraine, in what the White House described as a “fantastic” one-hour phone call.
Muddled inflation expectations no help for Fed
Keeping inflation expectations under control is arguably a central bank’s most important job. But it is also one of the most challenging given that the picture painted by the surveys, models and market prices relied on by policymakers is, at best, unclear, and at worst, so muddled as to be barely useful at all.
That’s especially true today, and one more reason why the Federal Reserve is proceeding with caution.
Consumer expectations can, understandably, be volatile. The layperson is unlikely to have a firm grasp on how global supply chains, commodity prices or monetary policy lags affect prices. They could therefore easily be influenced – or spooked – by news headlines and current conditions. Survey responses are thus often based more on emotion than economic analysis.
This helps explain why the five-year inflation outlook in the University of Michigan’s latest survey of consumers jumped to 3.9% in February. That’s the highest since 1993, and was undoubtedly driven by legitimate fears about the impact U.S. President Donald Trump’s tariffs could have on prices.
Yet the New York Fed’s February survey tells a very different story. It shows that the U.S. public’s five-year inflation horizon was unchanged from January at 3.0%. Indeed, this report’s five-year outlook has been stuck in a 2.5-3.0% range for more than two years.
If that’s not confusing enough, financial markets’ long-term inflation outlook suggests there’s no need to worry at all.
Five-year/five-year forward breakevens, a measure of expected inflation over a five-year period starting in five years’ time, have been trending lower in recent weeks and were last trading around 2.1%. That’s the lowest in two years, significantly below current annual CPI inflation of 2.8%, and practically at the Fed’s 2% target.
This suggests investors believe tariff shocks will pass, the Fed will keep policy sufficiently tight to get inflation down, or growth will be weak. Or some combination of all three.
TENUOUS LINK
Given that consumer expectations, particularly over the shorter one-year and three-year horizons, are more volatile than market-based measures, how should policymakers make sense of these conflicting signals?
A Cleveland Fed paper from October 2021 suggests they should be taken with a grain of salt. It found that the predictive relationship of a range of inflation expectation gauges was hit and miss. And much more miss than hit.
Researchers found that consumers are particularly bad at predicting inflation. Again, this may be no real surprise given that people without a financial background often struggle to distinguish between the price level and the rate of price increases.
Though, for what it’s worth, the Cleveland Fed researchers found that financial markets’ predictive power isn’t that much better.
Another 2021 paper by Fed staffer Jeremy Rudd went further, warning that the relationship between expected and actual inflation “has no compelling theoretical or empirical basis and could potentially result in serious policy errors.”
That’s a troubling conclusion given the importance policymakers put on keeping inflation expectations anchored.
But Fed Chair Jerome Powell doesn’t seem worried. Speaking to reporters on Wednesday after Fed officials cut their GDP growth projections but raised the inflation outlook, he insisted that long-term expectations remain well-contained even if short-term ones are rising.
The recent University of Michigan survey was an “outlier”, but will still be factored into policymakers’ thinking along with all the other indicators they look at.
“We monitor inflation expectations very, very carefully, every source we can find. We do not take anything for granted,” Powell said, adding that anchored inflation expectations are at “the very heart of our framework.”
What could move markets tomorrow?
If you have more time to read today, here are a few articles I recommend to help you make sense of what happened in markets today.
I’d love to hear from you, so please reach out to me with comments at . You can also follow me at [@ReutersJamie and @reutersjamie.bsky.social.]
Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias.
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(By Jamie McGeever, editing by Deepa Babington)
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