US - What will trigger the Fed put?

Markets have increasingly priced in a ‘Fed Put’: a substantial easing of rates to support financial markets during significant downturns. Markets now price in more than 100 bps of cuts this year, compared to 75 before April 2nd and roughly 50 bps in the first two months of this year. We think it is unlikely that the Fed will ease this strongly, because of a combination of the current macro constellation and signature and timing of the shock, through the lens of the recent inflationary episode and unprecedented government policy uncertainty.

We’ve seen the Fed respond to varying degrees to quick market deteriorations in four episodes: Black Monday, the LTCM crash, the great financial crisis (GFC) and around the Covid period. They represent an S&P500 market decline ranging between 5 and 40% in the month preceding the Fed stepping in, typically with the primary goal of achieving market stability. The current decline of about 20%, concentrated in the last week, does put us firmly within this range. At the same time, equities declined by more than 20% over a one month period in July 2002 as well, with no Fed response. It’s not a certainty. The collapse in markets could have an outsize impact on consumption beyond that implied by the tariff shock though, and therefore we consider a number of scenarios below.

The hard macro data advocates against easing and is unlikely to give a strong signal soon.

Compared to previous episodes, inflation is substantially elevated and unemployment is low, making the case for cutting aggressively much harder. The tariff shock is likely to increase inflation and unemployment, further helped by DOGE layoffs. Data will soon start to reflect these shocks, but the full impact will take a long time to feed into the hard data. Firms have likely stocked up on inventory, such that price markups may be more gradual while supplies last. DOGE layoffs will only end up in payroll figures in the last quarter of the year due to deferred resignations. Survey data is showing some weakness, with weakening confidence, sentiment and PMIs. A hard datapoint to look out for is the investment component of 2025Q1 GDP, which may have decreased substantially considering the enormous level of uncertainty. Still, it is not high rates that would be causing that, and it is therefore also unlikely that easing would provide a strong stimulus without resolution of the uncertainty.

Uncertainty is unlikely to be resolved anytime soon.

Powell explicitly noted that the FOMC would require more clarity before changing rates. While Liberation Day has passed, and we have an idea about the magnitude of the tariff shock, we have no clue about how long it will last, whether it will escalate or de-escalate, and how much retaliation there will be. Uncertainty has hardly declined. Previously exempt goods, such as pharmaceuticals, have again received tariff threats, but it is unclear when and how they will take effect. The Fed will be hesitant to go on an easing path based on a certain trade policy, only to have to reverse course soon after.

Having not even finished the inflation fight, a new inflationary shock risks deanchoring expectations.

Inflation has yet to return to the Fed’s 2% goal, and has even been accelerating somewhat recently. It is important for the Fed to continue this fight. If the public and financial markets no longer believe the Fed will stick to its price stability mandate, their behavior will change. Stability of expectations influences economic behavior, including wage-setting, price-setting and investment decisions. When inflation expectations are well-anchored, it is therefore easier for a central bank to steer the economy back to price stability. Wages and prices will be set according to the long-term goal, preventing a self-fulffilling cycle of inflation where expectations lead to preemptive price increases leading to actual inflation.

Recent University of Michigan Survey data showed a worrying increase of 5-year inflation expectations increasing to 4.1%, a 30-year high – the highest level since the Fed has had its 2% target. This Friday we’ll get the April update. In the last FOMC press conference, Powell tried to ease worries, noting that financial market expectations were still well anchored. Indeed, inflation expectations based on 5Y-in-5Y inflation swaps remain around the 2.5% they’ve been for a long time, although there is a positive correlation between changes in the Michigan inflation expectations and future changes in the swap rate. The first signs of deanchoring are therefore showing, and easing at this point may drive long-term inflation expectations away from the anchor. This could later necessitate a much more forceful and more damaging response from the Fed to bring expectations back to levels consistent with 2% inflation.

Current market pricing of the Fed path is only consistent with half the shock: a substantial increase in unemployment with inflation remaining near its current level.

We consider the average over a set of plausible Fed reaction functions to inflation and unemployment. Based on the Fed’s own projections last March, the current effective fed funds rate is at 4.33%, slightly more restrictive than the model implied level. About three 25bps cuts would be possible by year-end. In order to see the sensitivity to the Liberation Day shock, we take the baseline March Fed projection and add two impulses: 1) unemployment increases by 0.2pp per quarter, to reach 5.6% by 2026Q4 2) inflation increases by 0.2pp per quarter up to 4%, and then it stays there until 2026Q4. We believe the inflation impulse is reasonable, if perhaps somewhat slow, while the unemployment shock seems excessive, especially in the context of weakening labour force growth. If we add this unemployment impulse to the Fed projection, we get an implied Fed path that is quite close to current market pricing. The implication is that markets are pricing a scenario where unemployment increases, but inflation hardly rises, with core PCE staying at 2.8% until end of 2025 and getting closer to 2% throughout 2026. If we add both the inflation and unemployment impulses, we get a path that is mostly stable until well into 2026 when some easing might be possible. With this increase in inflation, the unemployment rate would have to increase by 0.4pp per quarter to 7.3% by 2026Q4 to be consistent with current market pricing. As for our our own base case, where inflation increases more rapidly, and unemployment increases less rapidly, the set of Fed reaction functions suggest some hiking is in order. We think the gap between the current policy rate and the one implied by this path is too small for the Fed to act, and will simply keep rates at this level. There would be some room to ease in the second half of 2026, which is now formally reflected in our base case.

The Fed has to balance its dual mandate, but the growth and labour market shock would have to be very substantial for the Fed to let inflation increase unchecked.

Based on the above macroeconomic considerations, we now expect the Fed to keep rates at their current level until 2026H2, where, starting in Q3 they will gradually ease with 25 bps per quarter. As for market volatility, functioning and stability, it is clear that the most effective course of action would be a change of government policy, not Fed policy. The Fed stepping in might help calm markets in the short-run but not solve the underlying cause. In some ways, the interaction between the Fed and the US government resembles that between the US and its major trading partners, though less openly. The Fed stepping in is implicit dealmaking with the Trump administration, with very little reason to believe the Trump administration may not escalate further. Unless the Trump administration is willing to back down and resolve part of this shock, it is unlikely that the Fed will join the race to the bottom.