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Participants noted that economic activity and labor markets remain solid, though inflation is still somewhat elevated and progress toward disinflation has been uneven. They flagged the announced tariffs as significantly larger and broader than anticipated, and emphasized that heightened uncertainty surrounding trade, fiscal, immigration and regulatory policies has made the economic outlook unusually murky.
Downside risks to growth and employment and upside risks to inflation have risen, largely tied to the anticipated impact of tariffs. Business contacts widely reported plans to pass through higher costs to consumers, with some firms eyeing broader pricing opportunities. While long-term inflation expectations remain anchored, some participants saw a risk they could drift upward — especially as short-term expectations and firms’ pricing power have increased post-pandemic. Tariffs on intermediate goods and renewed supply disruptions could further entrench inflation.
Despite continued strength in labor markets — with low unemployment, steady payroll gains and moderating wage growth — participants warned of potential softening, with firms increasingly cautious on hiring amid elevated policy uncertainty. Consumer spending has held up, but deteriorating sentiment and tariff-induced price pressures could weigh on demand. A shift toward precautionary savings or weaker financial market sentiment could further dampen consumption, although household balance sheet strength and lower energy prices may cushion the blow.
Business investment grew solidly, but sentiment has soured. Firms are delaying capital expenditures, particularly manufacturers, retailers and small businesses, who face cost pressures and supply risks. The agricultural sector and energy producers are under strain, and public institutions are contending with funding cuts and immigration limits. Some participants highlighted offsets, including healthy corporate balance sheets, ongoing trade negotiations, and the potential boost for less exposed domestic firms.
On financial stability, participants flagged increased market volatility and unusual asset price correlations — rising Treasury yields and a weaker dollar despite falling equities — as potential signs of deeper structural shifts. They stressed the importance of Treasury market resilience, noted vulnerabilities in private credit and hedge fund leverage, and acknowledged that tighter financial conditions or an economic downturn could expose fragilities despite generally solid balance sheets.
The Fed staff revised their outlook down, projecting weaker GDP growth in 2025–26 as announced trade policies imply a larger and earlier drag on activity than previously assumed. Productivity and potential output are also expected to suffer, widening the output gap over the forecast horizon. The labor market is forecast to weaken notably, with unemployment rising above its natural rate this year and staying elevated through 2027.
Inflation is now seen as markedly higher in 2025 due to tariffs, with a smaller impact in 2026, before easing back to 2% by 2027. The staff emphasized elevated uncertainty around trade and broader policy, viewing recession risks as nearly equal to the baseline. Inflation risks are seen as balanced in 2025 but skewed to the upside thereafter, amid signs of stickier inflation expectations.
Participants reaffirmed their commitment to the 2% inflation goal and the importance of anchoring long-term expectations around that target. In light of recent inflation dynamics, they weighed the trade-offs between current FAIT and FIT. While FAIT had merit in a low-inflation, effective lower bound-constrained world by helping guard against de-anchoring of inflation expectations to the downside, its benefits appear diminished in today’s environment of more frequent, larger inflationary shocks.
Participants generally favored FIT as a more robust and transparent approach, better suited to correcting persistent inflation deviations — whether above or below target — without committing to inflation makeup. In doing so, they signaled a shift away from the post-pandemic FAIT experiment, aligning the policy framework with a more volatile macroeconomic landscape.
The Federal Reserve held the federal funds rate unchanged at 4.25–4.50% at the May Federal Open Market Committee (FOMC) meeting. The unanimous vote reinforced the Fed’s wait-and-see stance, with officials signaling little urgency to adjust policy amid rising uncertainty around the economic outlook and increasing upside risks to inflation and unemployment. During the press conference, Fed Chair Jerome Powell repeated about 25 times that the Fed was well positioned to “wait” for greater clarity before considering any policy adjustments.
The policy statement saw few changes. The FOMC stressed that swings in net exports disrupted economic data while reaffirming that labor market conditions remain “solid” and inflation “somewhat elevated.” The Committee noted that uncertainty around the economic outlook has increased “further” and judged that “risks of higher unemployment and higher inflation had risen.”
While no new dot plot of fed funds rate expectations was released, we believe the policymakers’ median expectation has not shifted as much as market pricing. Markets are currently pricing in three 25 basis points (bps) rate cuts starting in July; however, we think the FOMC median still anticipates just two cuts in the second half of 2025.
The Fed’s reaction function was a central focus during Powell’s press conference. When facing trade-offs between the dual mandates — maximum employment and price stability — Powell emphasized assessing the relative distance to each goal and the expected timeline for convergence. This framework arguably predisposes the Fed to respond more slowly to economic weakness, particularly since inflation remains above target and employment is at — or slightly beyond — the goal.
Powell was candid about a scenario in which both inflation and the unemployment rate could rise due to tariffs, describing any policy decision in that context as “a complicated and challenging judgment.” He refrained from speculating on how the sharp decline in private sector confidence would feed through into “hard” data, noting that the link between sentiment indicators and consumer spending has been weak in the post-pandemic period. Still, given the speed and magnitude of the shock to sentiment, it would be misguided to dismiss the recent softness in soft data outright.
Throughout the press conference, Powell emphasized that given the general resilience of the economy, there was “little to no cost” to waiting for greater clarity on the economic impact of trade policy. With uncertainty around the scale, scope, timing and persistence of tariffs, Powell stressed that it would not be optimal for the Fed to preemptively adjust policy — especially with inflation still running above the 2% target.
On several occasions, Powell was pressed on the Fed’s pain threshold for the unemployment rate. He repeatedly declined to offer a precise figure, instead emphasizing the importance of monitoring a broad set of labor market indicators and noting that unemployment has remained low, hovering around 4%.
Powell also noted that the inflationary impact of tariffs could prove short-lived — reflecting a one-time upward shift in the price level — or that it could be more persistent. Encouragingly, he appeared inclined toward cautious accommodation if the economy weakens meaningfully as a result of tariffs, largely because he views tariff-induced inflation as transitory within the context of well-anchored inflation expectations.
The Fed Chair firmly deflected concerns about threats to the Fed’s independence. Nonetheless, we caution that even perceived political influence over monetary policy could unsettle markets. A loss of confidence in the Fed’s autonomy risks de-anchoring inflation expectations, lifting long-term yields, raising debt servicing costs and undermining demand for dollar assets.
Overall, we believe incoming hard data overstates the economy’s resilience. The moderation in headline personal consumption expenditures (PCE) inflation to 2.3% year over year (y/y) in March, and in core PCE inflation to 2.6% y/y supports the case for cautious policy easing. Indeed, we believe that while inflation will pick up toward 3.5-4.0% y/y because of the tariffs, second-round effects will be limited. Demand destruction from the tariffs along with pressures on employers to offset higher input cost will keep a lid on wages.
For now, we maintain our baseline scenario of gradual policy easing. Our central case continues to anticipate three 25bps rate cuts in 2025, though we have shifted the timing of the first cut from June to July, with the remaining two expected in September and December. We emphasize that postponing the initial rate cut raises the risk that policymakers may need to accelerate the pace of easing later in the year to avoid falling behind the curve.
The views reflected in this article are the views of the author(s) and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.
