• No change in rates: Fed Funds range is 4.25% to 4.5%.
• Sharp reduction in economic growth outlook.
• Projects two rate cuts later this year — but less sure.
• Slowing down the balance sheet runoff.
   

Gearshift

“The more things change, the more they stay the same.” Well, sort of. Last September, inflation registered 2.5% and was drifting lower, unemployment stood at 4.2% and the Fed Funds lower bound rate stood at 5.25%. Through the end of 2024, the Fed cut Fed Funds by 1% and has stood still since. Inflation has ticked back up to 2.8%, and the unemployment rate is unchanged. One would be forgiven for wondering why the Fed changed short-term rates at all.

What did change at this meeting were concerns over the economy slowing and balance sheet runoff. The Committee’s press release did not mention Federal layoffs or DOGE. The statement did show the Committee has the rate gearshift in hand and is ready to lower rates if the economy continues to slow. The new phrasing: “Uncertainty around the economic outlook has increased.” Sentences regarding the “solid” labor market and “activity has continued to expand” were unchanged from prior meetings.

The expected change in the Fed’s balance sheet runoff will start in April. We had expected a slowdown in runoff to start in the summer. A quick review: The Fed buys Treasury Bills and bonds directly from the Treasury and in the secondary market. This portfolio of Treasury securities peaked after shutdowns at $8.9 trillion in April 2022.

The Fed’s balance sheet is now $6.8 trillion, a decline of just over $2 trillion. Long term, the Fed’s goal is to get the portfolio down to around $4 trillion. The runoff of $2 trillion was achieved by the Fed not reinvesting proceeds from maturing bonds. To slow the runoff means as bonds mature each month, the Fed will take more of those proceeds and reinvest them into Treasury securities. Buying more bonds each month places more dollars into the banking system or the Treasury. The Committee voted to increase the amount of dollars into the banking system by $20 billion per month. 

Up and down 

Each quarter, the Committee receives updated economic forecast numbers from Fed staff. The Fed now sees inflation finishing this year higher at 2.7%, up from 2.5%. They also estimate that the unemployment rate rises to 4.4%, a slight increase from today’s 4.1%.

Those readings in turn pull down their GDP forecast for this year from 2.1% to 1.7%. They also see 2026 GDP growth running below trend at 1.8%. We think all these changes represent a tacit belief by the Fed that tariffs and DOGE will impact the economy. We would assert that Congress cutting spending over the next few years would be throwing sand in the economy’s gears after four years of $2 trillion per year in excess spending. 

No change

We believe the Committee will continue to keep short-term rates at these levels for most of this year. Back in January we wrote: 

Behind closed doors the Fed would like to have three or four more rate cuts. Its focus is not inflation — doubtful it ever was — but global liquidity and debt costs. Lowering our interest rates closer to the rest of the world would lower the value of the dollar relative to foreign currencies. This makes trade easier.

Interest rates have barely budged in the six weeks since that note, but the dollar is 4% lower, a meaningful drop. “Getting interest rates closer to the rest of the world” meant that our rates would drop. Instead, plans by European governments to rearm against Russia have sent their interest rates at least a half of a percent higher, up toward our levels. Tariffs do not push inflation as much as Keynesian economic models suggest. We believe that by the time the dust settles late this year that changes in dollar exchange rates will accommodate reciprocal tariffs.

What then is the correct level for short-term rates? Powell believes he has the cards to accommodate faster growth or the now-consensus soft landing slowdown. Powell’s press conference statement telegraphed they have their hand on the gearshift: “We’re at a place where we can cut, or we can hold.” For a Fed Chair, that is a clear statement that they are ready to move rates if the hard data directs them to. Of course, the next question is, “how far does the data have to move?”

The “dot plot” of Committee members’ opinions on short-term rates gives a hint to their thinking. Nine members marked down two cuts this year, compared to 10 in December. Eight members now think there will be one or no cuts this year. Only four members thought that in December. Four months of data later, at least four members see that the economy is strong enough to not require much in the way of rate changes. 
 

Summary

Short-term rates will not change in the next few months. Fed Committee members see a minor slowdown this year as businesses adjust to tariffs and D.C. sorts out tax cuts and possibly lower Washington employment. We honor the maxim, “Do not fight the Fed.” Down the road they still want lower rates.

Our base case has the economy slowing in the second half of the year, though sentiment and soft surveys suggest we are in a growth swoon at the moment. Our low case places recession odds at 30% this year. Those odds and the Fed’s outlook will get their first test with the April 4 unemployment report.

Please let us know how we can help you. 

Steve Orr is the Managing Director and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. Steve has earned the right to use the Chartered Financial Analyst and Chartered Market Technician designations. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary’s University School of Law. Follow him on Twitter here. 

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