The Federal Open Market Committee (FOMC) recently updated its predictions about interest rates. They foresee an average rate of 3.9% by the end of 2025. This could mean either two cuts of 25 basis points or one cut of 50 basis points. Rates are expected to decline slightly to 3.6% in 2026 and 3.4% in 2027, with a long-term estimate remaining at 3%. The Federal Reserve has also revised its economic outlook. This year, the U.S. GDP is expected to grow by 1.4%, down from a previous estimate of 1.7%. In 2026, growth is anticipated to be 1.6%, lower than the 1.8% expected in March.

Unemployment Outlook

By the end of 2025, the unemployment rate is likely to rise to 4.5% and stay there in 2026, which is above the March estimate of 4.3%. For inflation, PCE (Personal Consumption Expenditures) is forecasted to be 3% this year, up from 2.7%. By 2026, inflation may drop to 2.4%, still above the earlier prediction of 2.2%. The PCE index is expected to be 2.1% in 2027, with core PCE revised to 3.1% for 2025, up from 2.8%. Overall, the Federal Reserve’s updated outlook points to a slower approach to easing interest rates. The dot plot shows only slight decreases in the policy rate over the next few years, despite lower growth expectations and higher inflation forecasts. This suggests that the Fed is not convinced that inflation risks have decreased enough to act decisively. The projected 3.9% rate for 2025 indicates either two minor cuts or one bigger cut. Compared to nine months ago, the chance for quick, consecutive rate cuts seems much less likely. Instead, the trajectory looks steadier. This steady path indicates that the Fed is hesitant to ease policy too soon, especially while inflation remains above target levels. The market appears to be grappling with the expectation that growth will slow, the job market will weaken, and inflation will moderate—but not swiftly enough to trigger significant interventions. The message seems to be that the Fed is willing to wait. Chair Powell can’t commit to softer policies until inflation data shows lasting changes rather than monthly fluctuations.

Inflation and Economic Implications

The recent updates to both headline and core PCE inflation are significant, even more so than the GDP downgrade. The central bank believes inflation will return to its target over three years, rather than rushing towards 2% in the next year. This raises the likelihood of prolonged periods with rates higher than neutral. Expectations for unemployment are also noteworthy. The higher forecast suggests a softening jobs market, but not a complete collapse. A gradual rise to 4.5% may reflect the effects of earlier tightening rather than new shocks. It could indicate that rates are intentionally kept high enough to slow job growth, similar to strategies seen in the early 2000s. For those exposed to interest rate changes, it’s important to note that the long-term rate remains anchored at 3%. This stability puts pressure on parts of the yield curve and raises implied volatility for 2025–2026. The period leading up to then is filled with uncertainty, which may present unique opportunities. We should also keep an eye on what’s *not* changing. The Fed’s long-term inflation assumptions have barely shifted, even as short-term numbers come in stronger than expected. This implies confidence in their framework rather than the data. If high inflation continues, they might need to reassess their stance sooner. In the short term, we must watch the gap between actual inflation and market expectations. The Fed’s slow approach makes front-end pricing sensitive to data surprises, particularly those related to monthly inflation and labor market conditions. This is where we can see positive outcomes. Volatility in the market is starting to reflect this back-and-forth. Implied rates volatility has increased, especially for shorter maturities, but is still well below last year’s highs. This is a choice made by the Fed. Their caution has narrowed the scope of debates. However, missteps in policy or unexpected ongoing inflation could change that quickly. What we’re experiencing now isn’t a pivot; it’s more of a pause with an eye on the future. Any market dislocations may be temporary, but they offer chances, especially if timing aligns with data—especially if interest rate expectations rise when sentiment was more optimistic. From our perspective, assuming policy normalization is just that—an assumption. Those anticipating quick easing might need to reevaluate their positions, especially at the front end. The current carry is positive, but its trajectory could vary widely. Ultimately, it will depend on the Fed’s patience versus its capacity. Create your live VT Markets account and start trading now.

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