According to a report from Financial Associated Press on March 17 (Editor: Xiaoxiang), as the week of the Federal Reserve's interest rate meeting approaches, Fed Chair Powell will face a tricky task: both reassuring investors that the economy remains robust and conveying that policymakers are ready to act when necessary.

Despite the Fed chair's high-profile promotion of the resilience of the U.S. economy, the anxiety triggered by the rapidly escalating trade war under Trump over the past month has led to a significant drop in U.S. stocks, a decline in bond yields, and a sharp drop in consumer confidence due to heightened concerns about the economic outlook.

"Powell needs to send some sort of signal indicating that they are paying attention to the situation," said Dominic Konstam, macro strategy head at Mizuho Securities USA. He warned that while the Fed chair may explicitly state that officials are not targeting the stock market, policymakers cannot ignore the recent setbacks in the market.

White House policy gloom

Regarding the interest rate decision itself, although there is a general expectation that the Federal Reserve will almost certainly maintain the benchmark interest rate at the meeting on March 18-19, the traders in the interest rates futures market currently believe there is a high likelihood of three rate cuts this year—likely starting in June.

This will undoubtedly make the interest rate dot plot, released quarterly by the Federal Reserve, a focal point for attention. In the dot plot from December of last year, Fed officials generally expected two rate cuts this year. Some investors warn that if officials continue to signal only two rate cuts by 2025, then the Fed chair may need to emphasize that the central bank is willing to adjust borrowing costs if the labor market is weak.

"From a marginal effect perspective, the Fed may slightly improve or worsen the situation," said James Athey, portfolio manager at Marlborough Investment Management, "but obviously they cannot fully reassure the market because the impact on market sentiment mainly comes from the White House."

These impacts from the White House, in addition to escalating and erratic tariff threats against the USA's largest trading partners, include the fact that the Trump administration hasn't taken many measures to mitigate the risks of a recession in the USA. Trump stated on March 9 that the USA economy is facing a 'transition period,' and his Treasury Secretary Scott Pfenning even declared that the USA and the market need to 'detoxify.'

Currently, the two-year Treasury yield, which is most sensitive to the Federal Reserve's monetary policy, has dropped nearly 60 basis points from its peak in mid-January, reaching a low of 3.83% this month, marking a new low in more than five months. Although US stocks rebounded last Friday, they had previously experienced a fierce sell-off.$S&P 500 Index (.SPX.US)$It has also fallen 10% cumulatively from its peak, entering a technical correction area. The so-called 'fear index' VIX on Wall Street soared to its highest level since August last year last week.

As Federal Reserve officials are set to release the latest economic forecasts this week that may reveal how they view the economic impact of Trump's policies, these market fluctuations undoubtedly raise the risks of decision-making. It is expected that Federal Reserve policymakers will slightly lower their growth forecasts for this year on Wednesday, while raising their core inflation outlook excluding food and Energy.

Dilemma

However, Powell may still be reluctant to 'commit' to investors that the Federal Reserve will act immediately when the economy shows early signs of fatigue without any key prerequisites: officials will need to see more evidence that inflation is sustainably moving towards the 2% target and that future price growth expectations remain stable.

Sarah House, a senior economist at Wells Fargo & Co, stated, 'We may still hear the same old message: the economy remains robust, and the current policy is well-positioned, allowing the Federal Reserve to respond to stubbornly high inflation or more pronounced economic slowdown. But now I would like to hear more details on how they can more clearly balance their dual mandate.'

The Federal Reserve's long-standing 'dual mandate' includes promoting price stability and full employment. Although the rise in the USA Consumer Price Index (CPI) slowed in February, and the Producer Price Index (PPI) remained unchanged from the previous month, the components of the Federal Reserve's preferred inflation measure—the PCE price index—remained largely resilient. Meanwhile, a closely watched indicator measuring long-term inflation expectations has risen for the third consecutive month, climbing to a level not seen in over thirty years.

Deutsche Bank chief US economist Matthew Luzzetti stated that this data limits the Federal Reserve's ability to support the economy before signs of economic fatigue are more directly reflected in the labor market. He pointed out that specific signs of fatigue may manifest as weak non-farm payroll growth, rising unemployment rates, or surging layoffs.

"There is a lot of uncertainty, and these factors may translate into hard data, but policymakers will remain on the sidelines, waiting to see if this will happen. At the same time, I believe they are seeing more evidence that their task of combating inflation is not yet complete," Luzzetti stated. He expects that the Federal Reserve will not cut interest rates this year.

According to a previous industry survey of economists, if the Federal Reserve encounters economic weakness while inflation remains high, two-thirds of respondents expect that Fed officials will keep borrowing costs unchanged.

The complexity of the Federal Reserve's policy outlook is also influenced by other policies proposed by the Trump administration, such as tax cuts and deregulation, which may boost the economy and inflation in a matter of months. Powell and his colleagues have emphasized that they are monitoring the "net effects" of Trump’s policies and wish to have a clearer understanding of the overall impact before adjusting their policies.

"Despite high uncertainty, the US economy is still in good shape," Powell stated earlier this month at an event in New York (which was also his last public speech before this week's policy meeting). "We do not need to rush into action; we are fully capable of waiting for clearer signals."

The uncertainties surrounding balance sheet reduction.

In addition to interest rates, Wall Street strategists will closely watch for any hints from the Federal Reserve regarding pausing or further slowing the pace of balance sheet reduction—also known as Quantitative Tightening (QT). The minutes from the Fed's January meeting showed that several participants noted it could be appropriate to consider pausing or slowing the reduction of the balance sheet until the debt ceiling issue is resolved.

The minutes at that time indicated that Federal Reserve officials believed it had become a challenge to gain a clear read on market liquidity with the US government endlessly debating spending plans and the statutory borrowing limit affecting how the Treasury manages cash.

In other words, many Federal Reserve officials are concerned that, due to the interference of the debt ceiling issue, it is difficult to know whether the financial market still has sufficient liquidity. This is crucial for the Federal Reserve to continue reducing its holdings of USA Treasuries and mortgage-backed securities.

The guiding principle for the Federal Reserve's balance sheet reduction is to transition Bank reserves from an 'excess' state to a 'sufficient' state, that is, to end the balance sheet reduction before reaching a 'shortage', in an effort to prevent a recurrence of events similar to those in September 2019. At that time, excessive liquidity was withdrawn from the financial system during the final stages of quantitative tightening, forcing the Federal Reserve to actively re-inject liquidity.

In this regard, Blake Gwinn, head of Interest Rates strategy at Royal Bank of Canada Capital Markets, stated that the rationale for supporting the March action is that the Federal Reserve has already discussed this, so it might as well be implemented - they could completely pause QT first and restart it later.

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