Quick View: Is the Fed’s stance in March less balanced than meets the eye?

As we had expected, today’s statement by the Federal Reserve (Fed) emphasized what it views – at least on the surface – as balanced risks to both sides of its dual mandate. But investors need to recognize there are different kinds of balance.

On one hand, balance could describe smooth sailing, marked by steady growth accompanied by muted inflation. On the other, it could indicate that both consumer prices and the labor market face material risk.

The Fed currently finds itself confronting the latter scenario. As we largely concur with the Fed’s assessment, we believe this is not the time for bond market participants to source additional risks – either within duration or credit exposures – but instead to maintain vigilance, looking for evidence that may indicate the need for de-risking portfolios or reallocating risk to jurisdictions that have clearer visibility into the path for inflation and economic growth.

What updated projections don’t reveal

As the market expected, the Fed left its benchmark overnight rate unchanged, keeping it between 3.50% and 3.75%. At first blush, the update to the U.S. central bank’s Summary of Economic Projections (SEP) also appears to reflect what investors had anticipated. Economic growth expectations for 2026 were modestly adjusted upward – more so for 2027 – and both headline and core (excluding food and energy) inflation forecasts were raised for both years.

While increasing headline inflation to 2.7% for this year may reflect volatility in energy markets given the events unfolding in the Middle East, 2026 core inflation also being revised upward to 2.7% proves more noteworthy. As Jerome Powell intimated – in perhaps his penultimate press conference as Fed Chair – the voting committee would like to see more evidence that the inflationary effects of tariffs were a one-off. At the same time, the committee must also assess whether an energy price shock could be “looked through” rather than become more persistent. Gaining a line of sight into either of these phenomena is hard enough; seeking to understand both concurrently is especially challenging.

It was on the subject of inflation that that the tone and direction of Chairman Powell’s comments began to diverge from a relatively mundane SEP. While not going so far as to interpret Powell’s comments as hawkish, the degree to which he emphasized the risk to prices, especially compared to recent meetings, hinted that inflation – perhaps even prior to the Iran conflict – was unsettling voting members.

We had expected  Mr. Powell to express a lack of conviction on the future policy path, but his pushback that even one cut is assured in 2026 stands in contrast to the Fed’s 2025 view of multiple cuts, as well as that of an equally – if not more so – dovish market. Within this context, the lack of adjustment to the Fed’s widely followed dots survey – still one cut each in 2026 and 2027 – appears less like a roadmap and more like a placeholder until  the medium-term impact of tariffs and energy market disruptions on consumer prices become clearer. Further reinforcing this view is Powell’s refusal to rule out the possibility of future rate hikes.

An uncomfortably soft labor market

The other side of this tense balance – labor market weakness – does not make the Fed’s job any easier. It was a soft jobs market that likely compelled the Fed to preemptively cut rates in December despite persistent above-target inflation. Since then, the labor market has not improved, with Powell calling out very low private-sector employment growth, with the bias remaining to the downside. And while he rejected the use of the term “stagflation”, the combination of a weak labor market coupled with sticky consumer prices harkens back to that distant, but not forgotten, concept from the 1970s.

An overlooked risk?

Perhaps what we expected least in the Fed’s updated SEP was economic growth being revised upward to 2.4% in 2006 and 2.3% in 2007. Squaring this with a soft labor market is a challenge. Perhaps the Fed has adopted the market’s bullish view that the massive artificial intelligence (AI) buildout and that technological revolution’s impact on productivity – and thus economic – growth will be profound. The same assessment could be behind the Fed now seeing the long-term, neutral policy rate residing at 3.1% versus the 3.0% it expected last year.

While we share optimism around AI’s potential, we are vexed that the market is only viewing the Middle East conflict through the lens of inflation. Yes, shutting down the Strait of Hormuz is putting upward pressure on energy products – especially in Asian markets – but we believe investors may underappreciate the risks to growth posed by a prolonged supply shock. This could occur through demand destruction across segments of the economy exposed to hydrocarbon prices, as well as for consumers and industries that rely upon oil, gas, and petroleum products to cut back on spending elsewhere.

A time for prudent positioning

It is notoriously difficult to predict how geopolitical events could unfold. Our view that an extended conflict in the Middle East could impact already tenuous labor markets. Persistent inflation leads us to be cautious about increasing duration or credit risk at present, especially with credit valuations still relatively expensive in historical terms.

With the Fed intimating that a series of rate cuts is unlikely and much of Europe and developed Asia facing higher energy prices, the odds are decreasing that bond investors might count on future rate cuts to boost returns. It remains, however, a low probability that the Fed could pivot to increasing rates in the near term. Consequently, we believe that higher-quality, shorter-dated securities could potentially present investors with a balance of yield, capital preservation potential, and diversification against riskier assets, while limiting exposure to the higher volatility historically associated with longer-dated securities in periods of elevated economic and geopolitical uncertainty.

Lastly, recent developments reinforce our view that investors with the appropriate risk tolerance and objectives might consider a global approach to fixed income allocations. Varying exposures to Middle East energy products along with the knock-on effects on economic growth might contribute to differences in monetary policy among major developed markets. Allocating globally could provide opportunities for investors to balance yield generation with capital preservation amid an uncertain global economic environment.

IMPORTANT INFORMATION

Artificial intelligence (“AI”) focused companies, including those that develop or utilize AI technologies, may face rapid product obsolescence, intense competition, and increased regulatory scrutiny. These companies often rely heavily on intellectual property, invest significantly in research and development, and depend on maintaining and growing consumer demand. Their securities may be more volatile than those of companies offering more established technologies and may be affected by risks tied to the use of AI in business operations, including legal liability or reputational harm.

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa.  The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

Investing involves risk, including the possible loss of principal and fluctuation of value.