by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment opens with our takeaways from today’s rate decision and what we could gather from the Fed’s communication. We then turn to the market’s reaction to the decision, examining its impact on equities and fixed income. Next, we briefly cover the EU’s push to have Canada become an associate member, as well as signs that AI companies are developing their own methods of self-regulating. As always, we conclude with a review of recent domestic and international economic data.

Fed Rate Decision: In an effort to curb inflation, the Federal Reserve unanimously voted to raise interest rates for the first time since 2023. The decision also signaled that the central bank is prepared to tighten monetary policy further. This increase in the federal funds rate comes amid an improving economy and rising energy prices, which have sparked concerns about inflation becoming unanchored. Furthermore, the move reinforces the central bank’s independence from political pressure.

• The rate decision cemented the Federal Reserve’s hawkish shift following weeks of speculation. The latest Summary of Economic Projections showed that Fed officials have revised their outlook for rates at the end of the year from remaining unchanged at 3.50%-3.75% to 4.00%-4.25%. The increase is driven by a rise in the central bank’s expectations for both growth and inflation, suggesting that it is no longer worried about the employment side of its mandate.
• During the press conference, Fed Chair Kevin Warsh emphasized that the rate decision was part of the central bank’s mission to return inflation to target. He noted that while Fed officials acknowledge they do not have control over some of the supply drivers of inflation, the rate increase was designed to prevent the second- and third-order effects those drivers could cause. He also suggested not only that Fed officials had judged conditions to be unrestrictive prior to the increase, but that current rates may still be accommodative.
• While Fed Chair Warsh was reluctant to offer much forward guidance, he did acknowledge one indicator that appears to be informing the decision-making process: the dispersion of inflation. According to Warsh, the share of components moving away from the 2% target was among the indicators that supported a rate hike at this meeting. Warsh previously noted that 54% of components were above 3%, down from a post-pandemic peak of 77%, but still well above the 22% seen prior to the pandemic.
• The Federal Reserve’s hawkish shift signals that its commitment to the 2% target remains intact. The Fed will likely receive some relief this month when the PCE updates its methodology, which is anticipated to show downward revisions to inflation. Thus, while the Fed appears hawkish and has signaled a willingness to hike rates further this year, there is still a chance that incoming data could lead it to hold steady.

The Market’s Take: The Fed’s decision to raise rates left more questions than it answered. While the market had largely priced in the possibility of a hike at the meeting, it seemed ill-prepared for the hawkish shift in the Summary of Economic Projections. Caught flat-footed, investors triggered a selloff across several securities and a rally in the dollar as lingering concerns about the direction of monetary policy persisted. The reaction serves as a reminder of how dependent the market has become on forward guidance, and how bumpy the adjustment may be without it.

• Despite the market being up prior to the Fed’s decision, several securities sold off during the session, a sign of position liquidations. The shift comes as investors look to reposition themselves following a change in Fed rate expectations. The Nasdaq 100 finished the day slightly higher, suggesting that investors remain confident in the technology sector, while gold was one of the worst performers, declining by about 1% following the announcement.
• One of the more noticeable market shifts following the announcement came in the yield curve, which underwent a bearish flattening as the short end rose faster than the long end. The 2-year Treasury yield rose roughly 10 bps, the 10-year finished the day up 6 bps, while the 30-year was roughly unchanged. The flattening reflects expectations that a hawkish Fed could weigh on growth without tipping the economy into recession.
• While the question going into the Fed announcement was whether it would tighten, the next few weeks will be about how much. The Fed has faced some pushback from the White House over its decision, but that has not yet impacted market rate expectations. The latest CME probabilities suggest the Fed could hike two to three more times this year, with only a 10% chance that it will leave rates unchanged. This sharp shift in outlook reflects a broad belief that the Fed will maintain independence in its rate decisions.
• The market reaction to the Fed was likely a knee-jerk response and may not reflect the view going forward. Sentiment should improve as the market obtains more information about the state of the economy, since higher interest rates and a moderation of concerns regarding oil supply should help alleviate inflation fears. While there may be some worry over White House meddling, we think the market will pay less attention to it now that the Fed has signaled it will hike, which should also provide some stability.

EU-Canada: The European Commission has pushed for Canada to become its first associate member. The move has already drawn the ire of President Trump, who recently indicated that the US and Canada were close to reaching an agreement. In response, he has described the EU’s outreach as a hostile act and has communicated a willingness to raise tariffs. The move is likely another example of the US’s desire to ensure a united North American trade policy as a precondition for maintaining ties with its North American allies.

AI Safety Risk: OpenAI unveiled a new framework on Wednesday for disclosing and tracking risks associated with rogue AI models. In the release, it reported previously undisclosed incidents in which AI behaved in ways counter to its intended use, including instances of concealing or fabricating information to return results. The move by the AI provider comes as tech companies look to demonstrate their ability to self-regulate in hopes of preventing the government from introducing new restrictions.

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