The Fed has split into two camps over future interest rate path, BCA Research says

The Federal Reserve's latest projections reveal a split among policymakers regarding the impact of potential tariffs on inflation, with some anticipating no rate cuts this year and others expecting 50 bps of easing by the end of 2025. While the Fed held rates steady at 4.25%-4.5%, projections indicate a slower pace of rate cuts in 2026 and 2027, and policymakers now anticipate inflation to end 2025 at 3%, with growth decelerating to 1.4% and unemployment rising to 4.5%, signaling a potential period of modest stagflation.

Analysis

The Federal Reserve's latest interest rate projections highlight a significant divergence among Federal Open Market Committee (FOMC) policymakers, largely centered on the anticipated inflationary effects of potential tariffs. Seven FOMC participants foresee no interest rate cuts this year, concerned about sustained tariff-induced inflation, whereas eight expect 50 basis points in reductions by the end of 2025, believing the impact will be more transitory. BCA Research analysts align with the latter view, suggesting firms will be reluctant to raise prices despite potential tariff pressures, noting well-contained prices in May. While the Fed held rates steady at 4.25% to 4.5% and its "dot plot" still indicates two 25-basis point cuts this year, the projected pace of easing for 2026 and 2027 has decelerated. Policymakers now anticipate inflation will end 2025 at 3%, growth will slow to 1.4%, and unemployment will rise to 4.5%, painting a picture of modest stagflation. Fed Chair Jerome Powell acknowledged that tariff impacts are likely and could cause a "meaningful" rise in consumer prices, adding that rate path projections are held with little conviction. Reflecting this uncertainty and the evolving economic outlook, BCA Research recommends bond investors maintain "above-benchmark portfolio duration on a cyclical investment horizon and hold duration-neutral 2-year/10-year Treasury curve steepeners," and also maintain a "tactical short position in the January 2026 fed funds futures contract."

Key Decisions for Investors

• Investors should closely monitor incoming inflation data, developments in trade policy, and Federal Reserve communications for signals that might resolve the current divergence in policymaker outlooks and provide greater clarity on the future path of interest rates.
• Consider adopting a cautious stance towards risk assets given the Fed's projections for modest stagflation, characterized by 3% inflation and 1.4% growth by end-2025, and rising unemployment to 4.5%.
• For fixed income allocations, evaluate BCA Research's recommendations to maintain above-benchmark portfolio duration, hold duration-neutral 2-year/10-year Treasury curve steepeners, and consider a tactical short in January 2026 fed funds futures, particularly if anticipating a more protracted period of inflation or slower rate cuts than currently priced.