The Federal Reserve Spooks the Market Late at Night, Global Panic Spreads

At Wednesday's FOMC meeting, the Federal Reserve voted 11 to 1 to keep the federal funds rate unchanged at the 3.5% to 3.75% range for the second consecutive time, while continuing to maintain plans for rate cuts. Against the backdrop of this decision, the Iran war has led to an increase in energy prices, which may prolong the Fed’s longstanding battle with inflation.

The reason for holding steady: "three swords" hanging overhead

Inflationary pressures have not yet subsided. The Fed's preferred core PCE index (an inflation gauge) accelerated to 3.1% in January. The Producer Price Index (PPI) for February also exceeded expectations, reflecting that inflationary pressures were already building up even before the escalation in the Middle East situation. Prices for everyday services continue to climb, and these pressures cannot be attributed to tariffs, indicating that inflation demonstrates endogenous stickiness.

The labor market sends mixed signals. Employment growth has essentially stalled, the rise in unemployment has been limited, and the decline in the labor force is not due to reduced job demand. Powell admitted that recent trends in the labor market "carry signs of downside risks," and the current equilibrium "is not particularly reassuring."

External shocks amplify uncertainty. Turmoil in the Middle East and surging oil prices. The Federal Reserve statement explicitly pointed out that the impact of the Middle East situation on the U.S. economy "remains unclear." Facing a supply shock that simultaneously threatens higher inflation and slower growth, standing pat has become the consensus choice.

Future rate path: Moderately hawkish, with narrower internal divergence

The dot plot largely holds, but details reveal a hawkish tilt. The median projection remains for one rate cut (25 basis points each) this year and next. However, the number of officials expecting a rate cut in 2026 decreased, and even the most dovish forecasts raised the expected rate level at the end of 2026 by 50 basis points. The Fed raised its estimate of the long-term neutral rate from 3% to 3.125%, suggesting the terminal policy rate may end up higher than previously expected. Powell made it clear that rate cuts would require "as yet unseen progress" on inflation, especially improvement in tariff-driven goods inflation.

Internal differences have actually narrowed. In December last year, three officials still considered a rate hike appropriate for this year, but now that number has fallen to zero. Even Milan, who previously called for 150 basis points of cuts this year, lowered his expectation to 100 basis points. The only dissenting vote remained from Governor Stephen Milan, who advocated a 25 basis point cut, but his stance has clearly moderated compared to before. This indicates that committee views are converging toward the center, not toward the doves.

The timeline for rate cuts faces the risk of being postponed. Powell noted that the inflation brought by tariffs is expected to fall back around mid-year, which in effect pushes a meaningful rate cut window into the second half of the year. If the oil price shock persists, it may further constrain policy space.

Market risk appetite declines, expectations repriced

Interest rate markets: Yields rise, rate cut expectations cool. Within an hour of the announcement, both two-year and ten-year U.S. Treasury yields rose by 3 basis points. Investors repriced based on federal funds rate futures, lowering expectations for 2026 rate cuts, but still retaining a bet on one cut this year.

In the foreign exchange market, the dollar strengthened while emerging market currencies came under pressure. The U.S. Dollar Spot Index rose by 0.5%. The combination of firmer U.S. Treasury yields and surging oil prices led to broad pressure on emerging market assets. The S&P 500 index fell 0.4%. The market initially breathed a sigh of relief as the dot plot maintained a median expectation of one rate cut this year, but later read the statement and other officials’ forecasts as overall hawkish, which tempered rate cut expectations and dragged the stock market lower.