The Federal Reserve will conclude its two-day policy meeting and announce its latest policy rate. Although the market widely expects the Fed to remain on hold, a significant strategic shift is quietly underway beneath the surface.

According to the Fed's latest quarterly economic projections, most officials anticipate one to two rate cuts this year. At first glance, this forecast appears largely consistent with the outlook from December last year, when most officials projected two rate cuts. However, the underlying rationale has shifted significantly due to the looming threat of a trade war.

Analysts suggest that the core issue of this Fed meeting is not whether to cut rates, but how to adjust its policy framework amid an uncertain economic outlook. While inflation data has shown signs of easing, providing room for rate cuts, the potential threat of a trade war may compel the Fed to adopt a more cautious stance.

The Shadow of Trade War and the Battle Over Inflation Expectations

The Fed could cut rates due to good news like falling inflation, as was the case last year, or due to bad news like an economic downturn.

Currently, the likelihood of the first scenario has diminished as the possibility of Trump imposing comprehensive tariffs is rising. Trump reiterated during a speech at a joint session of Congress that reciprocal tariffs would begin on April 2. Treasury Secretary Besant stated that every country would receive a "tariff number" by that day, indicating the level of tariffs they would face. Meanwhile, U.S. trade partners are preparing for a potential trade war.

Historical experience suggests that a trade war could disrupt supply chains, fueling domestic inflation while stifling economic growth. This stagflation risk puts the Fed in a dilemma. Jay Bryson, chief economist at wells fargo, noted: "If inflation goes up, you want to be tightening. On the other hand, if the unemployment rate goes up, you want to be loosening."

Fed officials are no strangers to the potential impacts of a trade war. During the Trump 1.0 era, the Fed responded to the economic shocks of a trade war with rate cuts. However, the scale of the current trade war could far exceed previous episodes, and inflation has remained above the Fed's target for four consecutive years. This poses a greater challenge for the Fed in navigating the trade war.

Michael Reid, senior U.S. economist at rbc Capital Markets, stated businesses are now more focused on passing costs onto consumers, and this ability to pass on costs could further drive inflation, and the Fed must remain vigilant about whether public inflation expectations are beginning to form a self-fulfilling cycle.

A More Cautious Fed: No Action in the Next Six Months?

Several Fed officials have indicated that they would be more cautious if there are signs that the public expects inflation to persist. Central bank officials are particularly focused on ensuring that consumers and businesses expect inflation to remain low, as these expectations can become self-fulfilling.

Powell previously stated that the Fed is in no hurry to cut rates, seeking to buy some breathing room: "The costs of being cautious are very, very low. The economy is fine, it doesn't need us to do anything, really, and so we can wait and we should wait."

Boston Fed President Eric Rosengren said he expects the Fed may remain on hold for the next six months, taking little action.

He noted that he had anticipated tariffs would keep the Fed on hold for most of this year. However, he also expressed surprise at the scale of tariff increases already in effect and those potentially on the horizon, which have exceeded his expectations.

The Fed's rate projections cannot easily capture the various potential outcomes that could lead to rate cuts or maintaining rates. Philadelphia Fed President Patrick Harker said last month that he was hesitant between one or two rate cuts when he had to submit his projections in December.