June 20, 2025
The Fed did exactly what everybody expected it to do – nothing. It left the funds rate in a range from 4.25-4.5%. But the projection materials it provides quarterly indicate two things. First, in a stagflation scenario where GDP growth weakens but the inflation rate rises, the Fed will — at least temporarily — abandon its 2.0% inflation target and choose to lower the funds rate to counter the slower growth and rising unemployment rate. Doing so makes us wonder why the Fed even has an inflation target if it is going to abandon it when it refuses to cooperate. Second, there is an almost even split amongst Fed officials about the appropriate level of the funds rate at yearend. A narrow majority expect slower growth, a slight increase in the unemployment rate, and an increase in its preferred inflation measure from 2.8% currently to 3.1%. That is the world that will lead to two rate cuts between now and December. But there is a slightly smaller contingent that envisions a roughly similar economic environment but opts for no change in the funds rate. Such a wide divergence of views amongst Fed officials is rare, but it highlights the uncertainty in the economic outlook for the months ahead.
The Fed expects GDP growth for the year to be 1.4%. For what it is worth, we expect GDP growth of 2.5%. We believe that the magnitude and duration of tariffs will be mitigated in the months ahead by bilateral trade agreements between the U.S. and many other countries — including Canada, Mexico, China, and the European Union.
The Fed expects the unemployment rate to rise from 4.2% to 4.5% by December. That represents some softening in the labor market between now and then, but with the full employment level of the unemployment rate at 4.2% it is only mildly disquieting.
On the inflation front the Fed expects the core personal consumption expenditures deflator to climb from 2.8% currently to 3.1% by the end of the year. This is the inflation measure that the Fed targets at 2.0%. The Fed now says that the target will not be reached until 2027. The Fed has not officially abandoned its inflation target, but when the inflation rate does not continue to improve it extends the time frame it will take to return to its target. The problem is that the Fed lost so much credibility in 2020 and 2021 when it insisted the runup in inflation was temporary and that did not happen. As a result, the Fed was 18 months late in beginning to raise the funds rate. As a result of that policy blunder it almost certainly had to boost the funds rate to a higher level than would have been the case if it had acted sooner. All of this raises a question about its commitment to its 2.0% inflation target. It is not trying very hard to achieve that target any time soon.
With the expectation of 1.4% GDP growth for the year, the unemployment rate at 4.5%, and inflation at 3.1%, the Fed indicated that it expects to cut the funds twice by the end of year. We question the appropriateness of such a policy given the still very high level of the inflation rate. We acknowledge that a stagflation scenario makes the Fed’s job challenging. Should it respond to the rising unemployment rate which reaches 4.5% versus its full employment level of 4.2% by cutting rates? Or should it respond to the 3.1% inflation rate compared to its 2.0% target and not cut rates at all? We believe that the wide and rising gap between the observed inflation rate and its target should take precedence. After all, inflation of 3.1% is not even close to its 2.0% target. The Fed’s other target, the 4.5% unemployment rate is only slightly above its desired 4.2% level.
The press highlights the fact that the Fed still anticipates two rate cuts between now and yearend. But the projection materials indicate that there is a wide divergence of views about the appropriate level of the funds rate in December. There are 19 members of the FOMC — 7 Fed governors and 12 Reserve Bank presidents. Only 12 vote for the appropriate level of the funds rate at any given meeting, but all 19 submit their economic projections. While 8 members expected two rate cuts between now and yearend, 7 expected the funds rate to be unchanged. The Fed publishes the median forecast which is the one that gets the most votes – in this case the two-cut scenario. But if only one other Fed official had opted for no change that would have become the median forecast and the press would have reported that the Fed now anticipated no change in rates between now and yearend. The markets would not have liked that outcome.
The reality is that December is still six months away and much will be learned between now and then. The level of tariffs and their expected duration should become much clearer as will their impact on GDP growth and inflation. Much of the difference in views that exist amongst FOMC members currently will be resolved. Our guess is that whatever policy they choose at their meeting in December will be nearly unanimous.
Economists are used to dealing with uncertainty but there are different degrees of uncertainty and the current situation is probably unprecedented. To make their forecasts economists always have to make assumptions which today are largely centered on tariffs. Unfortunately, none of us have any idea how that might evolve.
Stephen Slifer
NumberNomics
Charleston, S.C.
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