Fed to keep interest rates steady as economic growth slows, tariffs dampen outlook

Vijay Valecha, Middle East Economy, May 5, 2025

The Federal Reserve (Fed) is set to keep interest rates steady on Wednesday as President Donald Trump’s tariffs raise uncertainty over the country’s economic outlook. Trump announced the steepest U.S. tariffs in a century, impacting consumer and business sentiment, and manufacturing. Tariffs have also triggered a massive import rush that has impacted the U.S. gross domestic product last quarter.

The Fed has held its policy rate in the 4.25-4.50 percent range since December. Fed policymaker projections from March point to two rate cuts this year. However, with new developments and tariff announcements, Fed Fund futures indicated four rate cuts by the end of 2025, taking the terminal rate to around 3.31 percent.

“The probability of interest rates staying the same stands at 94.8 percent, while the chances of a 25-bps rate cut stand at just 5.2 percent,” stated Vijay Valecha, chief investment officer, Century Financial.

Consumer spending grows despite slowdown

Fed policymakers expect tariffs to increase both inflation and unemployment. The economic data so far suggests that the U.S. economy will struggle due to levies. The economy contracted at an annualized rate of 0.3 percent in the first quarter of 2025, according to the Bureau of Economic Analysis (BEA), missing market forecasts of a 0.4 percent growth and coming down from the prior 2.4 percent expansion.

“The decrease in real GDP in the first quarter primarily reflected an increase in imports, which are a subtraction in the calculation of GDP, and a decrease in government spending. These movements were partly offset by increases in investment, consumer spending, and exports,” said the BEA.

Despite the unexpected GDP decline, consumer spending still grew at a 1.8 percent pace. The Labor Department’s jobs report on Friday showed that U.S. employers added 177,000 jobs in April, around 40,000 more than expected, and the unemployment rate remained steady at 4.2 percent.

Quarterly forecasts from the Fed are not due until June, so investor focus will be on Fed Chair Jerome Powell’s comments for further insights into the interest rate trajectory.

“Since the Federal Reserve started its policy pivot in September last year, a total of 100 bps of rate cuts have been initiated, and the rates have been held stable since late last year. A lot has changed since the pause in the rate-cut cycle was started, especially after President Trump’s aggressively protectionist policy stance with tariffs unveiled for countries worldwide, potentially disrupting global trade. This caused the Fed to raise inflation forecasts for 2025 and 2026, while reducing growth expectations for the year,” added Valecha.

Solid labor market gives Fed time

Last month Powell said he wanted to be “certain” that a temporary tariff-driven rise in prices does not become an ongoing inflation problem. A solid labor market would allow the central bank to delay cuts. However, Powell’s stance could change swiftly if the labor market starts to deteriorate, forcing the Fed to cut interest rates in order to achieve full employment even if inflation rises.

Most economists expect the Fed to ease interest rates in 2025, but many don’t think there is enough evidence of labor market weakness to justify a response until the summer. After the release of the April jobs report, some economists said they believe the Fed won’t reduce borrowing costs until July, a time frame that allows for more clarity on tariffs and the tax-cut bill.

“Although Trump’s administration has shown a renewed effort in trade negotiations with key partners, especially a softer stance on China, the economic outlook remains uncertain. The Fed stands at a critical juncture, with inflation expected to heat up following the implementation of tariffs, while a slowdown in economic growth could impact the labor market going forward. For now, the data-dependent Fed remains in a “wait and watch” mode, with rate cuts expected to restart in July,” added Valecha.

Valecha added that it is highly expected that the Central Bank of the UAE will follow the move of the Federal Reserve during the week, given that the UAE dirham is pegged to the U.S. dollar. If interest rates are held stable, the UAE central bank would most likely keep the Base Rate applicable to the Overnight Deposit Facility (ODF) stable, shadowing the Fed’s move. The benchmark interest rate is anchored to the U.S. Fed’s IORB and signals the general stance of monetary policy in both countries.

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