Fed treads carefully, leaving markets anxious about tariff risks

NEW YORK (Reuters) -A cautious Federal Reserve has put a damper on hopes for interest rate cuts, leaving investors on edge as they navigate a murky mix of geopolitical tensions, inflation risks, and looming growth drag from U.S. President Donald Trump's tariffs.

The Fed on Wednesday kept the benchmark interest rate unchanged, as expected. While policymakers reaffirmed that they expected some reduction in borrowing costs this year, they dialed back the anticipated pace of future cuts because of the potential for higher inflation amid uncertainty over the Trump administration's proposed tariff plans.

"The calm that the Fed has should be comforting to investors, but it also on the other hand reflects the incredible uncertainty that we have over all the data that is rolling forward," said Bob Savage, head markets strategist at BNY.

Investors on Wednesday clung to expectations for two quarter-point rate cuts this year, in line with the median expectation of rate-setting Fed officials. Rates futures traders were largely betting on a cut between September and October, and a second one in December.

The market remains on edge after the Fed slightly marked up the outlook for inflation this year. Fed officials revised inflation expectations to 3% this year from a previous forecast of 2.7%, June's summary of economic projections by the Fed showed. Economic growth forecasts for 2025 were revised to 1.4% from a March forecast of 1.7%.

Compounding the Fed's more muted economic expectations, a deepening crisis in the Middle East and its potential to push energy prices higher overshadowed a soft core inflation reading for May that had offered some relief to the market.

"There's not a lot of things out there that say inflation is going to crash to zero or negative, and so the skew is to the upside, and the Fed recognizes that," said Brad Long, chief investment officer at Fiducient Advisors.

U.S. Treasury yields edged higher after Fed Chair Jerome Powell warned in Wednesday's press conference that goods inflation could pick up this summer as tariffs begin hitting consumers. The S&P 500 ended nearly flat on Wednesday, giving back earlier gains after Powell's remarks.

Policymakers still anticipate cutting rates by half a percentage point this year, as they projected in March and December, but they slightly slowed the pace from there to a single quarter-percentage-point cut in each of 2026 and 2027, in a protracted fight to return inflation to their 2% target.

The number of officials projecting no rate cuts this year increased compared to March, according to the widely followed "dot plot" included in the summary.  

Robert Tipp, chief investment strategist at PGIM Fixed Income, said the outcome was hawkish. 

"This Fed is laser-focused on inflation," he said.

"They're willing to tolerate some weakness in growth."

HOT SUMMER

Trump has repeatedly pushed for lower interest rates, but on Wednesday Powell cautioned that a new wave of cost pressures may be on the horizon, as businesses across the supply chain wrestle with how to absorb tariffs.

"Every outside forecaster and the Fed is saying ... that we expect a meaningful amount of inflation to arrive in coming months, and we have to take that into account," he said on Wednesday.

Meanwhile, Trump said last week he would be willing to extend a July 8 deadline for completing trade talks with countries before higher U.S. tariffs take effect.

Blake Gwinn, head of U.S. rates strategy at RBC Capital Markets, said the July tariff deadline remained key for markets.

"If I'm thinking of risk events, that is one that looms pretty large from here," he said.

For investors, the inflation data in the coming months will be critical, said Michael Reynolds, vice president of investment strategy at Glenmede.    "The aggregate picture that they tell... is really going to be informing investors whether you see more of a risk-on rally on the back of rate cuts and expectations of rate cuts, or if we are still in this uncertainty holding pattern."

While the inflation outlook is cloudy, economic indicators are painting a picture of slowing momentum in the U.S. economy.

Employment growth has been losing steam in recent months and the housing sector is showing fresh signs of strain. Data out Wednesday revealed that housing starts plunged nearly 10% in May, marking their lowest level since the early days of the pandemic in 2020.

Stephen Dover, chief market strategist and head of the Franklin Templeton Institute, said he saw opportunities outside of the United States due to political uncertainty and concerns around inflation.

In the bond market, he was more positive on short-dated debt because tariffs complicated predictions over the long-term trajectory of bonds.

"It's a fool's errand to try to really predict what's going to happen with tariffs," he said. 

(Reporting by Davide Barbuscia; Editing by Alden Bentley and Diane Craft)