Fed conundrum
Will its next policy move be another pause, a cut or a hike? It depends.
Bottom Line
In perhaps his penultimate policy-setting meeting as its Chair, Jerome Powell and the Federal Reserve voted to leave the federal funds rate unchanged on Wednesday for the second consecutive meeting at a three-year low of 3.50-3.75%, as we and many others had expected. With an 11-1 vote to leave interest rates unchanged, the one dissent was from Federal Reserve Governor Stephen Miran, who voted for another quarter-point cut.
The Fed cut interest rates by a total of 75 basis points last September, October and December 2025, and by a collective 175 basis points over the past two years. But due to heightened uncertainty surrounding the recent military conflict in Iran and the sharp spike in energy prices, we expected the central bank to pause at this week’s meeting to assess the impact on already-rising inflation and deteriorating economic growth and employment.
Changes to the SEP In his post-meeting press conference with the financial media, Powell joked that if there was ever a meeting for the Fed to skip providing quarterly forecasts, “this would be a good one, because we just don’t know.” Nevertheless, in its new quarterly Summary of Economic Projections (SEP), the central bank raised its expectations for GDP growth for this year and in each of the next two years. It also increased its estimates for core PCE inflation this year and next, and it ticked its forecast for unemployment higher next year. The Fed continues to expect one additional interest rate cut this year and next.
GDP growth higher In its new March SEP update, the Fed raised its estimate for GDP growth this year from 2.3% in December to 2.4%, compared with 2.1% in 2025; its 2027 forecast from 2.0% to 2.3%; and its 2028 forecast from 1.9% to 2.1%.
However, GDP growth in the fourth quarter of 2025 was recently revised down by half to a gain of only 0.7% from a preliminary reading of 1.4%. This was largely due to the record 43-day federal government shutdown last October and November, which reduced federal government spending by nearly 17% and shrank overall GDP growth by 1.2 percentage points. But personal consumption was also reduced from a preliminary gain of 2.4% to 2.0%, and core private domestic final sales declined from a preliminary increase of 2.4% to 1.9%. So, Fed officials appeared willing to look through the extraordinary nature of the fourth-quarter weakness.
Productivity soaring Productivity growth has soared by an average of 4.1% over the last three quarters of 2025, compared with an average of 1.9% over the past 50 years. This is due to the 100% expensing provision for capital spending in the One Big Beautiful Bill that President Trump signed into law last July, which should help to moderate inflation over time.
Inflation rising In its new March SEP, the Fed increased its estimate for core PCE inflation (the Fed’s preferred measure) to 2.7% y/y in 2026, up from its December forecast of 2.5%. Core PCE inflation in January 2026 hit 3.1% y/y, up from a four-year low of 2.6% in April 2025. In 2027, the central bank ticked up its core PCE target from 2.1% in its December SEP to 2.2% in March. Its 2028 estimate is unchanged at 2.0%.
Labor market softens The official rate of unemployment (U-3) has risen from a 53-year low of 3.4% in April 2023 to 4.4% in February 2026, a level at which the Fed believes the labor market will finish this year. For 2027, it increased its U-3 estimate from 4.2% in its December SEP to 4.3% in March. Its 2028 estimate remains unchanged at 4.2%.
To be sure, the labor market weakened considerably in February 2026, losing 92,000 nonfarm jobs. But the brutal winter weather, a West Coast health-care strike, and a downward population revision of 1.4 million household workers contributed to the loss.
More recently, however, initial weekly jobless claims (an important leading indicator) declined to a two-month low of 205,000 for the survey week that ended March 14, which suggests that March payrolls could improve from disappointing February levels.
Fed on hold? In its March SEP, the Fed did not change its forecast for one more quarter point cut during 2026 and another in 2027. But the forecasts from individual Fed participants range from potential cuts to pauses to hikes, depending on how the growth trajectory of the economy, labor market and inflation unfold in coming months, quarters and years.
We here at Federated Hermes believe that the Fed is likely on hold through the Fed’s mid-year leadership transition to Chair-designate Kevin Warsh, at which point the Fed will assess progress on key economic metrics to inform future policy decisions. Longer term, we are still expecting three more quarter-point cuts over time, which would take the terminal value of the fed funds rate down to 3.0%. Nominal CPI inflation is at a 10-month low of 2.4% y/y in February 2026, which suggests that the Fed has room to cut if inflation remains well behaved.
Sand in the gears The problem is that crude oil prices (WTI) spiked from a five-year low of $55 per barrel in early January 2026 to $120 on March 9. Although WTI has eased to $98 now, concerns surrounding the three-week-old Iranian conflict have spawned fears of $150 crude oil or higher. Lagging gas prices have soared by 40% from $2.80 per gallon in January to $3.91 now.
Wait-and-see approach If the Iranian conflict lasts more than four to six weeks, and if this temporary spike in energy prices becomes imbedded in much higher persistent inflation, then the Fed’s most likely course of action would be to hike interest rates. But the deterioration in the labor market and the economy in recent months suggests that the Fed should be cutting interest rates to boost growth. So, what should the Fed’s monetary policy response be?
In our view, this week’s response was appropriate — take a deep breath, do nothing now, wait patiently for the Iran conflict to end soon, and hope that energy prices decline as quickly as they rose.
Read more about our views and positioning at Capital Markets.