Despite the significant surge in oil prices driven by the Iran conflict and a sudden increase in inflationary pressures, Bank of America maintains its forecast for two Federal Reserve interest rate cuts this year—one in September and another in October, each a 25 basis point reduction, totaling 50 basis points for the year.
The bank acknowledges that applying the Taylor Rule to the current outlook would suggest a rate hike or no change. The current forecast for cuts is based on three non-economic rationales: the Fed's tendency to look past supply shocks, continued focus on downside risks in the labor market, and political pressures.
However, a list of risks cannot be ignored. Should inflation persistently exceed expectations, the war last longer than anticipated, inflation expectations begin to rise systematically, or wage inflation rebound, the Fed might choose to hold rates steady entirely. Bank of America admits, "Our forecast is not on solid ground, with risks skewed towards no rate cuts this year."
**Renewed Supply-Side Shock: Fed's Historical Precedent is to 'Look Through'** According to analysis, Bank of America economists note that the Iran conflict presents another supply-driven stagflationary shock to the U.S. economy, following the Russia-Ukraine war and last year's tariff policies, once again putting the Fed's dual mandate—employment and inflation—in a difficult position. Risks of rising inflation and increasing unemployment are intensifying simultaneously.
Historically, however, the Fed has tended to "look through" such supply-side shocks rather than immediately tightening monetary policy, with its policy bias still leaning towards rate cuts. This stance was reflected in the March economic projections, where 12 out of 19 participants still anticipated at least one rate cut this year.
Bank of America believes that the recent ceasefire agreement—though fragile—increases confidence in its baseline forecast that the war will conclude by the end of the month. If the conflict ends this month, the pass-through of oil price increases into core inflation will be limited, and inflation expectations will remain anchored, allowing the Fed to downplay higher headline inflation data in the coming months.
**Labor Market: Stable, Not Overheated, Downside Risks Persist** The March FOMC meeting minutes revealed that "a vast majority of participants viewed risks to the employment side as tilted to the downside," with many seeing the labor market as "vulnerable to negative shocks."
Bank of America argues that the Fed's reaction function still assigns greater weight to downside risks in the labor market. The March jobs report was overall strong—nonfarm payrolls increased by 178,000 (against expectations of just 65,000) and the unemployment rate fell to 4.3%—but the bank points to soft signals: the U-6 unemployment rate edged up slightly in March, median unemployment duration lengthened, and the February JOLTS report indicated sluggish hiring and limited job openings.
A more critical structural change is that the labor market is far less "hot" than in 2022. The ratio of job openings to unemployed persons has fallen below 1.0 from a peak of around 2.0 in 2022, indicating significant excess capacity. The current market is characterized by a "low-firing, low-hiring" cool state, not the overheating seen in 2022. Bank of America also warns that, consistent with patterns in the summers of 2024 and 2025, this summer could again see softer nonfarm payrolls and increased layoffs, a pattern that paved the way for September rate cuts in the previous two years.
**Limited Wage Inflation Pressure: Powell's View Supported by Data** Fed Chair Powell stated clearly at the March press conference: "The labor market is clearly not a source of inflationary pressure."
Bank of America's data corroborates this: average hourly earnings for non-managerial and production workers rose only 3.4% year-over-year in March, with a Q1 annualized growth rate of 3.1%. Recent productivity gains have also substantially reduced unit labor costs, with growth rates well below 2022 levels.
Consequently, Bank of America contends that current inflation stems mainly from exogenous supply shocks like energy, rather than cost-push inflation from an overheated labor market. This provides a rationale for the Fed to focus its efforts on managing downside risks.
**Political Pressure Not to Be Underestimated: Warsh's Appointment is Key Variable** Bank of America explicitly lists "political factors" as the third pillar supporting its rate cut forecast.
The Senate Banking Committee has scheduled confirmation hearings for Kevin Warsh's nomination as Fed Chair for April 16. Although Senator Tillis (R-NC) has expressed reluctance to vote for confirmation until the Justice Department's investigation into Powell is concluded, Bank of America still expects Warsh to be confirmed and take office no later than the September meeting.
Once Warsh assumes leadership of the Fed, he would be able to steer policy options at each meeting in a more dovish direction. Assuming the Iran conflict is resolved soon, the fading effects of tariffs would improve sequential inflation data, and seasonal summer weakness in the labor market would support his dovish arguments, potentially securing enough votes for rate cuts this year.
However, Bank of America also highlights a counterpoint from history: in April 2008, Warsh publicly expressed concern about rising commodity prices, arguing that one "cannot wait until inflation expectations are unanchored to act, because then it will be too late." This historical context suggests Warsh's policy direction may not be as dovish as anticipated, especially if inflationary pressures persist.
**Growth Forecast Revised Down: Q1 GDP Tracking Estimate Cut to 1.9%** Regarding economic growth, Bank of America has lowered its tracking estimate for Q1 GDP growth from 2.2% to 1.9% (SAAR). The main drags came from February's core retail sales missing expectations and being revised down, lower-than-expected January business inventories, and February personal income and spending both falling short. Meanwhile, the final Q4 2025 GDP reading was confirmed at 0.5%, matching the bank's previous expectation.
For the full year, Bank of America has revised down its 2026 GDP forecast, projecting 2.2% growth on a Q4/Q4 basis and 2.3% average annual growth. Signs of cooling are already appearing in consumption: February real personal spending rose only 0.1% month-over-month, with the three-month annualized growth rate slowing to 0.8%. Conversely, the three-month annualized growth rate for headline PCE inflation rose to 4.1% in February, and further energy price increases will likely continue to weigh on real consumption in the near term.
**Inflation: Peaking in Q2, Remaining Above Fed Target Throughout Horizon** The energy price shock has significantly worsened the inflation outlook.
Bank of America expects headline PCE inflation to peak at 3.8% in Q2 2026, 70 basis points higher than its previous forecast, before declining rapidly as oil prices retreat. However, even after oil prices fall, the overall price level at the end of 2027 is still projected to be 30 basis points higher than previously forecast, reflecting rising food inflation and ongoing global supply chain effects.
For core inflation, the rise in energy prices will pass through to core measures with a lag. The bank forecasts core PCE at 3.1% for 2026 (Q4/Q4), up from a prior forecast of 2.8%, potentially falling to 2.5% in 2027. Overall, inflation is expected to remain above the Fed's 2% target throughout the forecast period.
**Consumer Data Shows Resilience, But Clear Divergence in Structure** Despite macroeconomic pressures, Bank of America's internal credit and debit card data for the week ending April 4 shows total card spending per household grew 6.5% year-over-year, a significant acceleration from the previous week.
Spending on gasoline & oil surged 20.9% year-over-year, directly reflecting the distortive effect of the oil price shock on consumption patterns. Entertainment spending grew 14.7%, grocery spending increased 10.5%, and online retail rose 11.0%, indicating some underlying support for consumer demand. In contrast, categories like furniture, home improvement, and department stores saw year-over-year declines, highlighting a clear divergence in spending patterns.
For investors, the core narrative remains that the Fed's dovish bias has not yet reversed, but uncertainty from the inflation shock is testing the boundaries of this stance. Whether a September rate cut materializes will largely depend on the sustainability of the ceasefire, the trajectory of inflation expectations, and the policy signals from Warsh once appointed—these three variables will be the most critical indicators to monitor closely in the coming months.
Comments