Fed likely to retain easing bias

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The US-Iran conflict shows few signs of letting up, but market focus today will likely shift to the Federal Reserve, which is widely expected to hold interest rates steady for a second time this year. S&P 500 futures are up 0.6% ahead of the US market open, while Brent crude oil has stayed above USD 100/bbl for a fifth consecutive trading day.

For the Fed, the outlook has moved from confidence in the US economy’s resilience to concerns about the war’s fallout, which may pull its policy goals in opposite directions. Policymakers will also provide their best-informed projections on growth and rates, despite the highly uncertain outcome of the war.

For investors, Fed Chair Jerome Powell’s press conference may offer clues on how the central bank weighs rising energy prices against labor market risks. Currently, fed fund futures are pricing in one 25-basis-point rate cut in December.

Since we do not expect a prolonged disruption to energy supplies from the Strait of Hormuz in our base case, we think the Fed’s policy easing bias remains intact.

Inflation is still likely to moderate as the year progresses. We expect Fed Chair Powell to stress vigilance over inflation, especially as some Fed officials had already flagged the risk of more persistent inflation before the start of the US-Iran conflict. But analysis by the Dallas Fed shows that the incremental price pressure due to rises in energy prices tends to fade quickly after a few months, with core inflation little changed. Current inflation is also lower than it was when the Russia-Ukraine war triggered spikes in energy prices, and top central bankers have in recent years suggested an eagerness not to overreact to one-off increases in price levels. With the Fed’s current policy rate still considered restrictive, we think the direction toward lower rates remains unchanged.

A weak labor market should keep rate cuts in store. While February’s weaker-than-expected payrolls likely reflects payback after a strong January, the report still points to downside risks in the labor market as job losses were broad-based across government, private services, and goods-producing sectors. The advancement of AI also poses a structural risk to the labor market, with recent job cut announcements from Block, Meta, Amazon, and Atlassian explicitly linked to the technology. In fact, if the digital sector laid off 2% of its workforce, the modest job gains in the US last year—the weakest since the pandemic—would flip to a loss.

The personnel profile of the Fed board is set for a dovish shift. While uncertainty surrounding the Fed leadership transition remains, the composition of the Fed board is likely to become more dovish later this year. Fed Chair nominee Kevin Warsh is expected to favor a looser monetary policy given his belief in the disinflationary effect of the current productivity trends. The seven permanent FOMC board voters also tend to be moderately more dovish than the median forecast. The Fed sets rates through a 12-member committee, which comprises seven governors and a rotating cast of five of the 12 regional bank presidents.

So, despite near-term risks that reduce the likelihood for imminent easing, we believe the medium-term policy trajectory still points toward lower rates. We continue to recommend maintaining a diversified portfolio that includes allocations to quality bonds and gold against the current backdrop.