While the Federal Reserve took no official action on interest rates at the March meeting, it was still a lively meeting. Up until now, Fed Chair Jerome Powell had been able to mostly avoid questions about President Donald Trump’s policies, usually by saying the Fed would wait to see the impacts. However with the stock market teetering and signs of consumer spending slowing, Powell faced even more pointed questions at his post-meeting press conference. More importantly, he started to give some real answers. Here’s our thoughts on what was said as well as the challenges the Fed will face in the coming months.
The economy definitely slowed in 1Q, but by how much?
There have been several data points suggesting that the economy slowed meaningfully in the first quarter. In January, consumer spending had the largest single-month decline since 2021. In February, consumer sentiment had the largest single-month drop in the nearly 50 years of that survey’s history.
The Atlanta Federal Reserve calculates a daily “GDP Now” forecast. GDP stands for “gross domestic product” and is a measure of total income in the economy. The GDP Now forecast is meant to synthesize day-by-day economic data and make a projection about where overall economic growth will ultimately be for that quarter. As of the morning of the Fed meeting, the forecast projected a severe -1.8% contraction, which would be a figure consistent with a recession.
Source: Federal Reserve Bank of Atlanta
Powell was asked several questions about potential economic weakness. While he admitted that the Fed Committee saw risks to the downside, he was fairly dismissive of the risk of imminent recession. He pointed out that things like government layoffs have a major effect on those impacted, but are small in the scheme of the economy.
The GDP Now figure does illustrate how difficult it can be to parse how the economy is doing. The trade deficit for January exploded by 25%, an unprecedented increase. This probably reflects companies and/or consumers rushing to buy imported goods before tariffs cause higher prices.
Technically, the trade deficit subtracts from GDP. This is essentially because spending on imports ultimately becomes income for some other country, not the U.S. However a country that is importing a lot of goods clearly has a lot of income in order to do so. In addition, the surge in imports is extremely likely to be a temporary phenomenon. Once tariffs are implemented, there is a good chance that imports drop substantially.
The Chair said that “we do not need to be in a hurry” to cut rates and that the Fed was “well positioned to wait for greater clarity.” That being said, the Fed revised down their internal estimation for 2025 economic growth from 2.1 to 1.7%. Clearly the Fed sees a weaker economy as a risk.
Drop in consumer spending more concerning
Powell also indicated that the recent data on consumer spending had the Fed’s attention. While Powell said that the labor market was “solid,” he said that “uncertainty around the economic outlook has increased.” He specifically cited consumer confidence as reflecting this uncertainty. Powell said that the Fed was “focused on separating the signal from the noise” but that this was a risk the Fed was “attuned” to.
The decline in consumer spending during January has seemed to come a bit out of the blue, which is likely making it challenging for the Fed to interpret. Typically consumers spend what income they have. In other words, consumer spending doesn’t tend to decline without first seeing declining incomes. Usually declining household income is caused by job losses. The latest data on both income and jobs were both reasonably strong.
As is typical, Powell did his best to avoid politics wherever possible. However it’s clear that enough consumers are worried about what might happen, presumably because of Trump’s policies, that it has impacted overall consumption.
It would not be surprising if this wound up being a short-term phenomenon. If household incomes remain strong, spending may rebound. That would fit the more typical historic pattern for consumer behavior. However it could also be that because Trump has so widely telegraphed tariff and government spending plans that the current period breaks the typical pattern.
The Fed is probably wise to not jump to conclusions either way.
Stagflation is one risk
Stagflation is where economic growth is weak but inflation is also high. This is a rare phenomenon. In order to get stagflation, the economy must suffer something called a “supply shock.” This is where some event causes the supply of goods to contract, typically because of a sudden increase in the cost of production.
Tariffs do exactly this. The tax on imported goods functionally increases the cost of producing those goods. Plus many domestically produced goods import some of the raw materials or parts. There again, the tariff increases the cost of production.
One big problem with stagflation is that it’s tough for the Fed to handle. If inflation is high, the Fed knows what to do: hike rates. If the economy is weak, the Fed knows what to do: cut rates. If both are happening at the same time, the Fed has to decide which of its mandated goals to favor over the other. It cannot fight both high inflation and weak economic growth at the same time. Anything it does to help alleviate one will exacerbate the other.
Powell was fairly dismissive of the risk of stagflation, saying the Fed’s base case is that inflation pressure from tariffs will be “transitory.” Perhaps part of why he is saying this is that recent inflation data has been encouraging.
Source: Bureau of Labor Statistics
After moving sideways for over a year, the most recent Core Consumer Price Index (CPI) dropped to its lowest level since early 2021. It looks like there was at least some positive momentum for inflation at the start of 2025.
Could tariffs erase this progress and push inflation higher again? Yes. But it also could be that tariffs keep inflation higher than it would otherwise be, but don’t actually cause inflation to outright rise. In addition, if the economy actually starts slowing, that alone would put considerable downward pressure on inflation. Again, tariffs won’t help, but they might get overwhelmed by other forces pushing inflation lower.
The Fed’s official forecasts suggest this is how the Fed is thinking similarly. As we said previously, the economic growth forecast was revised downward, but still positive. The inflation forecast was revised upward as well. Previously the Fed projected inflation would subside somewhat in 2025, whereas now the projection is for inflation to stay steady.
Hence, we think the odds of actual stagflation remain low. That’s good news in a sense, because it will provide clarity for the Fed’s decisions as the year progresses.
The Fed could rescue the market
Over the last several months, the election and tech earnings have been the dominant narratives in markets. Those aren’t going away anytime soon of course. However, the Fed could return as a key driver should the recent spate of economic weakness become a trend.
Right now the housing sector is providing very little to the economy. Housing construction is weak and existing home sales are at 2008 levels. In a more normal environment, housing construction would be a bigger source of direct economic activity. In addition, people moving from house to house tends to result in other spending too, such as buying furniture, making repairs, upgrades, etc.
The thing standing in the way of more robust housing activity is interest rates. Which of course, the Fed could solve. Powell can’t do this now, because inflation remains a problem. However, if the economy turns weaker, the Fed’s calculus will change.
Not only could lower interest rates spur more housing market activity, but it will also result in a large number of refinances. While many homeowners have very low mortgage rates from the pre-2022 era, anyone who bought a house in the last three years could realize significant savings if interest rates dropped. This could become a kind of stimulus, giving those households a larger budget for everyday savings.
We don’t think a recession is the most likely outcome right now, but it’s a risk. That this risk is rising is exactly why the stock market has struggled in recent weeks. However, bear in mind that the economy is always in motion. If economic growth does stall, it’s quite possible that the Fed could come to the rescue.
The Fed faces multiple risks
As the Fed said in the post-meeting press release: uncertainty has increased. The Fed doesn’t know whether inflation, economic weakness, or both could become a problem with which they have to contend. Right now the Fed’s own projections suggest there will be two rate cuts of 0.25% each in 2025. However that forecast isn’t worth much. How economic growth evolves during 2025, and subsequently how inflation plays out, could result in many more cuts, or no cuts at all.
