Will the Fed Cut Rates to Rescue Financial Markets?

No, we do not think the Federal Reserve will cut rates in the near term to rescue financial markets. However, if tariffs begin to significantly impact the real economy, the Fed will eventually act. The Fed faces a delicate balancing act: managing downside growth risks while addressing inflation pressures from tariffs. This dynamic will make the Fed hesitant to respond to financial market stress unless labor market conditions deteriorate. This delay increases the risk of greater equity declines. However, bonds have provided reliable defense during recent volatility, and they remain a key diversifier. If recession risks rise, the Fed will likely cut rates, which would benefit bonds. Investors should maintain bond allocations at policy portfolio weights.

Markets have reacted sharply since US President Donald Trump announced his reciprocal tariff plan on April 2. Global equities have fallen 16.5% from their February peak, while ten-year US Treasury yields declined as much as 70 basis points (bps) over roughly the same period. Bond yields reflect weaker growth expectations and the market’s anticipation of aggressive Fed easing. Federal funds futures now price in 100 bps of rate cuts by year end, double the Fed’s March projections. However, the Fed may disappoint markets by moving more cautiously, given the announced tariffs complicate the outlook. Initial estimates suggest tariffs could reduce US real GDP growth by 1 percentage point (ppt)–2 ppts but increase inflation by up to 2 ppts. This stagflation shock challenges the Fed’s ability to act decisively, as it must weigh inflation risks against growth concerns. While the Fed cut rates during the 2018 tariff episode, it is less likely to do so now due to heightened inflation risks. Fed Chair Jerome Powell recently emphasized that the central bank is still not in a hurry to lower rates despite the recent market volatility.

To be clear, this is not a repeat of 2022. At that time, the Fed was aggressively hiking interest rates in response to a spike in inflation caused by both a supply shock and pent-up demand following the pandemic. In contrast, the Fed lowered its policy rate by 100 bps in the past year in response to declining inflation and a normalization in the labor market. The Fed’s current target policy rate range of 4.25%–4.50% remains restrictive, well above its longer-run neutral rate of 3.0%. However, it paused further rate cuts following its December 2024 meeting to assess the impact of previous actions. While tariffs add complexity to this assessment, the Fed maintains an easing bias and the bar for rate hikes remains high.

There is a risk the Fed acts too late if it waits for clear signs of labor market weakness in response to tariffs. Recent data suggest the US labor market was reasonably strong ahead of the tariff announcement. The Fed faces a key challenge: forecasting the impact of tariffs on the labor market as most labor market data are either coincident or lagging indicators. This complicates the Fed’s decision making. The Fed will likely closely monitor timely indicators—such as survey data on hiring intentions or qualitative insights from its regional banks—for early warning signs about the labor market. So far, these indicators suggest softness but not outright distress. Heightened credit, liquidity, or funding market stress could prompt the Fed to intervene sooner, potentially through measures like expanded liquidity lines, quantitative easing, or other unconventional measures. However, the Fed will be hesitant to cut rates decisively absent a material increase in downside growth risks relative to upside inflation risks.

Bonds have been a reliable safe haven during the initial equity sell-off, but stagflation risks and tariff uncertainty have introduced volatility. Despite the potential for near-term fluctuations, bonds remain a critical diversifier. Tariffs may have a temporary US inflationary impact, but they could ultimately prove deflationary depending on their effect on the real economy. If recession risks grow, the Fed has room to cut rates significantly, as it has done in past downturns. Still, if a recession develops, then equities have more downside and Treasury securities should provide further protection. For example, US equity prices have fallen 18.0% from their February 19 peak through yesterday’s close. Comparatively, previous bear markets without a recession average a 23% decline, while those with a recession average a 39% drop. ¹ Bonds, meanwhile, have returned just 3% on average during equity bear markets without a recession, compared to 14% during recessions.

In sum, the Fed will likely wait for clear signs that the labor market is deteriorating before cutting rates. At that point, we could already be in a recession. In that eventuality, the Fed has ample room to cut rates, making bonds a reliable diversifier. Investors should maintain bond allocations at policy target weights.

TJ Scavone
Senior Investment Director, Capital Markets Research

Footnotes

1. For US bear markets, we include price decline greater than 19%, as opposed to the typical definition of 20%, to increase the number of observations.