June 13, 2025
This week Fed officials will gather to reassess their economic outlook and decide what to do with interest rates for the balance of the year. They will almost certainly opt to leave the funds rate unchanged at this week’s meeting. With regard to policy changes later they will indicate that it depends on a variety of factors. First, it will depend on the level and potential impact of tariffs on the economy and inflation. Second, it will depend on the roundup of migrants — legal and illegal – which has shifted into a higher gear and could reduce employment and GDP growth. And, if that is not enough, the Israeli attack on Iran has boosted oil prices which could both accelerate inflation and curtail growth in the months ahead. These latest developments have boosted the odds of a stagflation situation developing in the months ahead. That is the most devilish scenario any central bank can encounter.
GDP growth may be softening, but from what to what? All we know is that first quarter GDP declined 0.2% as a result of the surge in imports. Based on the April trade data imports are falling sharply in the second quarter. The Atlanta Fed GDPNow forecast suggests growth in that quarter could be 3.8%. GDP growth rates for both quarters are distorted but in opposite directions. Perhaps the best way to determine the underlying pace of economic activity is to average growth for the two quarters which would be 1.8%. At its latest FOMC meeting the Fed indicated that it expected 1.7% GDP growth for the year. Possible.
For what it is worth, we anticipate GDP growth of 5.0% in the second quarter and 2.5% growth in the second half of the year. Our sense is that the Fed’s forecast includes a bigger drag on growth caused by tariffs. But negotiations are underway with Canada, Mexico, China, and a variety of European countries. Trade deals would reduce the sting of tariffs and their negative impact on the economy. The problem is that no one – including the Fed – can predict how this might play out.
With respect to the unemployment rate, the Fed’s expectation for GDP growth of 1.7% for the year suggests that the unemployment rate should be essentially unchanged at its current level of 4.2% by yearend. But the labor market has been remarkably resilient in recent months. Further, what if second quarter and second half GDP growth turn out to be 2.5% or faster? The unemployment rate would be lower, not higher. The Fed expects the unemployment rate rise to 4.4% by yearend. That may not happen.
Then there is the inflation outlook. The Fed’s targeted inflation measure is the core personal consumption expenditures (PCE) deflator which came in softer than expected in both March and April and has risen 2.5% in the past twelve months. In the wake of Israel’s attack on Iran’s nuclear production facilities oil prices have jumped 12% or $8.00 overnight to $74 per barrel as fears mounted that the war could disrupt the supply of oil from the region. Thus far the attacks have been confined to nuclear facilities and not on Iran’s oil producing capability. Maybe that continues, but it is hard to predict once tempers flare and missiles are flying in both directions. The market’s fear is justified. If the war spreads and oil prices climb further the optimistic view of a further slowdown in the inflation rate will quickly disappear.
Fed officials next week will almost certainly leave the funds rate unchanged in a range from 4.25-4.5%, The outlook for the economy is muddy because both first and second quarter GDP growth rates will be significantly distorted. If the Fed does not know where the economy is currently, it is hard to have any confidence in their GDP forecast for the second half of the year.
Ditto for the unemployment rate. The labor market seems to be doing fine at the moment with only a minimal impact from tariffs and migration issues. Whether that continues or not will depend up the pace of economic activity in the months ahead, as well as further policy changes coming from the Administration.
Inflation has been a bright spot for the past couple of months, but it is at risk of jumping to the high side from the war and factors completely out of the Fed’s control.
For now the situation for Fed is abundantly clear – do nothing. If the factors cited above cause the economy to slow by more than what seems likely at the moment and the inflation rate to accelerate, the economy could be headed towards a stagflation environment. Ugh! Should the Fed raise rates to combat the faster inflation rate? Or should it lower rates to support the slower pace of economic activity and a rising unemployment rate? Only time will tell.
Stephen Slifer
NumberNomics
Charleston, S.C.
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