Fed to Hold Rates Despite Inflation: Top Economist's Supply-Driven Warning

Key Metrics

• Current Fed Funds Rate: 3.50%-3.75% (unchanged)
• May Inflation: 4.1% YoY (headline PCE)
• Core PCE Inflation: 3.4% YoY
• Policymakers Expecting Hikes: 47% (9 of 19)

Despite market pricing in a tougher Fed, top economist Greg Daco from EY-Parthenon argues the central bank will keep rates on hold due to supply-driven inflation pressures that rate hikes can't fix. With inflation at 4.1% YoY and Americans facing an income squeeze, rate hikes would hurt growth without solving the underlying inflation problem.

Fed's Hawkish Turn

At the Fed's June 17 meeting, nine of 19 policymakers forecast at least one rate hike by year-end, while the central bank kept rates unchanged at 3.50%-3.75%. This marked a hawkish turn from the prior meeting, when no policymaker had penciled in a hike.

Inflation Remains Elevated

According to the Bureau of Economic Analysis, the May PCE report showed headline inflation rising 4.1% from a year earlier and core PCE climbing 3.4%. Both measures remain well above the Fed's 2% target.

Supply-Driven Inflation Pressures

Daco argues that current inflationary pressures are primarily driven by supply factors rather than overheated demand:

• Higher energy prices due to the Iran war
• Strain from AI on limited resources
• Rising prices for computers and electronics

American Consumer Squeeze

Americans remain in an "income squeeze," with after-tax, inflation-adjusted income essentially not growing in May. This limits consumer spending growth and makes tighter policy potentially harmful without solving inflation pressures.

Energy Price Impact

The Iran war has significantly affected energy markets and consumers:

• Benchmark crude prices surged by $20 a barrel to $92 after hostilities began on Feb. 28
• National average gasoline price climbed to $4.56 a gallon, up 53% since the war started
• The war has cost the typical U.S. household about $1,000 so far

Wall Street Expectations

Despite Daco's view, Wall Street expectations are mixed:

• More than three-quarters of economists expect the Fed to keep rates unchanged through 2026
• Bank of America now expects three 25-basis-point hikes in September, October, and December
• Deutsche Bank expects two hikes, in September and December
• Goldman Sachs doesn't expect cuts until June and December 2027

Market Implications

If the Fed stays on hold:

• Treasury yields will remain elevated
• Rate-sensitive growth stocks will face pressure
• Consumer discretionary names, airlines, and retailers will face challenges from higher costs
• Energy stocks may benefit from higher oil prices

Interpretation

Daco's argument represents a significant shift in how the Fed's effectiveness is viewed. Traditionally, the central bank has used interest rates to combat demand-driven inflation. However, with inflation now primarily driven by supply constraints—energy shortages, AI resource demands, and other supply chain issues—rate hikes become a blunt instrument that may do more harm than good.

The Fed's challenge is that monetary policy cannot directly address supply-side problems. Higher rates won't produce more oil, add power capacity, or create extra semiconductors overnight. Instead, they risk slowing an already fragile economy without solving the underlying inflation pressures.

This creates a delicate balancing act for the Fed: maintaining a restrictive enough policy to prevent inflation expectations from becoming unanchored, while avoiding hikes that could push the economy into recession without addressing the root causes of inflation.

Outlook & Risks

Watch Points / Risks:

1. Energy price volatility remains a wildcard, with the Iran conflict potentially causing further price spikes
2. The Fed's communication strategy will be critical in managing market expectations
3. If inflation proves more persistent than expected, the Fed may be forced to hike despite Daco's warnings
4. Consumer spending could weaken more than anticipated if the income squeeze continues
5. Global economic conditions could impact the Fed's decision-making process