Should the Fed Focus on Inflation or Unemployment?

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week, we analyze what's happening in the markets and discuss how it might affect your investments.

Well, hi, Liz Ann. I wanted to start out this week something I've been thinking about since our last podcast and follow up with you. You mentioned that we haven't seen mass layoffs yet. And what we've seen is the unemployment rate's been holding fairly steady. Hiring is not too bad. Do you think we'll still continue see this sentiment, this consumer sentiment, be so weak and the expectation of rising unemployment given that things are still going along at a reasonable pace?

LIZ ANN: Yeah, you know, it's an interesting dichotomy right now, and it's sort of the poster child for the soft data versus hard data, given that many of the confidence measures, which would be in that soft-data category, survey-based data, have shown remarkable weakness, yet it's not at this point corroborated by the majority of hard-data indicators. And on the employment front, you're right to point out that spread. So within the consumer confidence data that we get on a monthly basis, that's put out by the Conference Board. They're the same group that puts out the index of leading indicators and coincident indicators and a number of other things. But within the consumer confidence report, there are a lot of individual questions that are asked of the survey respondents, and one of which is around expectations for the unemployment rate looking forward. 

And that's where we've seen an increase in terms of expectations for where the unemployment rate is going to be. And that does historically tend to track fairly closely with the unemployment rate with a little bit of a lag. It has not come to fruition yet. I think we're still riding a bit of a hard-data wave of economic strength that arguably predated the start of tariffs. My guess is unless we continue to see a rolling back of some of those tariffs, that the best-case scenario would be a bit of convergence, where we see a little bit of an improvement in the soft data around employment.

But I still think base case—and I'm curious to your thoughts on this—I still think base case is we're going to see a generally higher-trending unemployment rate. In fact, not to quibble with the numbers and math, but maybe worth pointing out that the unemployment rate did tick up. It just didn't move up on a rounded basis, given that the unemployment rate is reported to the 10th, not the 100th. So it's small, but a little bit more, and it would have gone from 4.2 to 4.3%. So I don't know if you're thinking in the past week with some of the data that has come in has changed, Kathy, but what are your thoughts on not just the labor-market backdrop, but the implications for the Fed, given that employment is half their dual mandate?

KATHY: Yeah, I was looking at that report and thinking, "Well, this really gives the Fed a pass for at least another month or two because they do have that dual mandate of full employment and keeping inflation in check. And it's really tough, even though there's some softness, as you note, under the surface here and likely a rise in the unemployment rate as we get into later in the year.

But, at this stage of the game, there's just not enough evidence for the Fed to do anything about that. And I will note, you know, the problem that the Fed has is that they don't have the luxury of pre-emptive easing in this cycle because inflation is too high. And they don't have a roadmap yet on what the tariffs will be so that they can analyze. The staff is probably analyzing a million scenarios, but how do you decide on which scenario is the most likely when everything's so fluid? They just don't have the luxury of cutting pre-emptively in this cycle, and therefore staying on hold is the path, not just of least resistance, but the only one that's sensible right now. So that's where we are, and we'll see how the data evolve, as Jay Powell continues to say, and they'll react to it. But they just can't be pre-emptive in this cycle.

LIZ ANN: It was the case that in the aftermath of the jobs report that market-based probabilities of the Fed cutting in June did drop a bit, but I haven't looked to see where they sit now. So what … based on fed funds futures, what is the market pricing in, not just for the next meeting or two, but for the rest of this year—is it still a couple of cuts?

KATHY: Yeah, it's still around three. So going in to the unemployment report, I think it was close to four. Now it's closer to three. I would pencil in two personally, because I think the Fed does wait. But the markets … it's very fluid, too. It's funny to me when Treasury Secretary Bessent said, "Well, the two-year is below the fed funds rate, and that's the market telling the Fed it should cut."

And I'm thinking, "That's not a game you want to play." Because immediately afterwards, the two year goes up 10 basis points. So you can't play that market game that way. You have to really have a long-term view. And so we'll see. I think the expectations are going to jump all over the place with every data point, which is what's been happening recently.

LIZ ANN: Are you still of the view that, because we've talked about, I think, on our pod here before, that as it relates to the arguably stagflationary impulses of a trade war that we'll get the growth slowdown before we get any meaningful tariff-related uptick inflation, or could it be more of a kind of an even race at this point?

KATHY: Yeah, my bias is to say we get the slowdown first because this is so well advertised. So it's a supply shock, but one that we can see coming. And as you've noted a number of times, businesses are already starting to react in terms of pulling back in investment and hiring. Consumers are very much focused on this and did some pre-emptive shopping in the first quarter, likely to slow down in subsequent quarters.

So I do think that the slowdown comes first. But again, this is a really tough one to roadmap. I mean, the pandemic was really tough because we hadn't had a pandemic in nearly a century. And this one is a tough one, too, because it's ever changing. And we don't even know who's negotiating yet and who isn't or what the terms of those negotiations might be. What does a good trade deal look like?

That might help us if we get one or two we could say "OK now we know what the what the parameters are for a good trade deal are." But at this stage, there's so much we don't know.

LIZ ANN: Yeah, and it's particularly murky as it relates to the forward-looking earnings outlook. I've got my monthly Market Snapshot video that I'm actually taping shortly after we're done with this, and it's all about earnings season to date and what has been a better-than-expected reporting season, but that reporting is for the first quarter of this year, which obviously concluded before the Liberation Day announcements and all of the heightened uncertainty that has followed, and one of the things I discuss in the video is the rising share of companies just withdrawing guidance all together because it's just an incredibly murky period of time, and companies don't have that visibility to give analysts guidance, so I think that's another important theme.

But back to the Fed, the rest of this episode here will be a little bit more about the Fed, and so looking forward to your conversation with our colleague Collin Martin. So tell our listeners who have maybe not heard a past episode with Collin, tell them a little about him.

KATHY: Yeah, Collin's a frequent guest on the show and a close friend and colleague of both of us. He's a director and fixed income strategist on my team here at the Schwab Center for Financial Research. He's also a Chartered Financial Analyst charterholder. And he's a frequent guest on Bloomberg TV. And he's widely quoted in financial publications, including Wall Street Journal, MarketWatch, Barron's, and Reuters. 

Collin, thanks for being here on Fed day.

COLLIN: Happy to be here. Thank you for the invite.

KATHY: So let's talk about the Fed meeting and decision or lack thereof. I thought it was interesting that the Fed chose not to change policy, but to highlight the risk of stagflation. So they didn't use the word "stagflation" but highlight the risk of inflation and slowing growth.

So that was my key takeaway. It's like, "Yeah, we're not doing anything, but this is what we're watching." What did you think about it?

COLLIN: So I'm with you where the meeting itself, the result was no surprise. No one expected the Fed to cut rates at all. We expected them to hold steady. What I thought was interesting is how they framed the decision looking at the here and now versus the risks that we might see down the road and what led them to hold rates steady. 

Now, if we looked at the statement, that's the first thing we get. We got the updated statement, and then there were no updated projections or dot plot, and then you had to wait a little bit before we heard Fed Chair Powell. The statement itself initially painted a somewhat positive picture. It stated that the economy remained solid. It actually went out of its way to highlight that that negative GDP print was mostly net-export driven. Under the surface, the statement said that the economy was still relatively solid and that the labor-market conditions were actually still solid. So they kicked it off with that. And I think that's why Fed Chair Powell kind of repeated the same language he's been using for a while about patience, and the Fed is not really in a hurry to cut rates. And I agree with that. If you look at the data right now, you don't need to. But the outlook is, I think, what's important. So a new line was in there, and the risks to both higher inflation and higher unemployment have risen. 

And that's obviously what everybody's been talking about and the possibility that the Fed's dual mandates or two mandates of price stability and maximum employment could be in conflict and which one they're going to focus on. So I think time will tell. It looks like expectations for future cuts have been pushed back a little bit. Markets are still generally pricing in about three rate cuts by the end of the year. What I'm going to be interested in to see how the data actually plays out, you know, will those mandates actually be in conflict? And then I think the big question, and I'll pose this to you, Kathy, is which do you think the Fed will focus on? If we do get the, you know, the risk of higher unemployment, so a weakening labor market and higher inflation, which do you think they're going to pay more attention to and then drive their policy decisions?

KATHY: Yeah, it's really tough. And the unspoken part of that at the beginning of the statement was, well, it's highly uncertain because of tariffs, right? That's really what's driving this uncertainty. And I do think that the Fed would have to respond to rising unemployment with easing policy, even if inflation remained too high, because I think the logic would be if the economy really slows down, unemployment rises, inflation will come down because demand will slow down. 

The real tough part about this decision right now, and I have sympathy for the Fed, is that they're looking at a policy that could change in a heartbeat, right? So it's unlike, say, COVID when, OK, you know, it came as a big shock, but once we knew what it was, we could sort of track the path of it and try to respond to it. Now, it's like, well, we have tariffs, and we have proposed tariffs, and we have counter-proposals, and then we have exemptions, and then one day, "Oh no, we're not going to put a tariff on this or on that or in this country or that country. We could wave a magic wand and make it all go away."

You know, they run a risk of responding by cutting rates because they see the economy slowing down and then have the tariff policy go away in a day, and that could push inflation higher. They could be easing into an inflationary environment, right? So I think the path of caution is the only one that they can really take right now until something's solidified that they can measure, and Powell did say interestingly they would look at their two mandates, inflation and unemployment, and they would kind of measure how far they were from each of them, and then, you know, if they got really out of whack on one of them, they would respond to that, and I think the assumption is the one that would get out of whack would be unemployment. And that would start to rise from 4.2% towards 5%. And deterioration in job growth, the Fed would respond by cutting rates. But I'm not assigning a high degree of confidence on my end as to what the outcome of all this is going to be because it's so fluid.

COLLIN: I'm really glad you brought that point up about how far away from the mandates, because I think that was really important. I think he laid out what they're thinking about, because that's the big question we have. How are they going to address that? And I think he did a pretty good job of explaining which way and how far are they from each of those mandates, as that will probably drive their decision-making. I agree with you, where I think they'll focus more on the labor market.

When we look at the potential for inflation, Powell also brought up the idea of, if prices rise, is that a one-time increase, or will they start to see persistent inflation? Because I think that will be a key driver. I'll add that if it is just a one-time price increase or even if we get … whatever the inflationary pressures are, long-term or short-term, I don't know if that's necessarily an interest rate problem. It's a trade policy problem.

So I don't know how much the Fed can do to combat that, but they can combat a potentially rising unemployment rate and weakening labor market. I want to follow up with you on something you mentioned before with the dual risks out there, the idea of stagflation. Now, that gets thrown around a lot and yes, I guess, definitionally, it gets thrown around, but I kind of have a few issues with that because I don't think it's as bad as stagflationary periods in the past, right? I mean, we're still at inflation of near 3% or less, and growth right now is still OK. Under the surface, we're still looking at trend growth or maybe even above-trend growth, 2.5 to 3%. So I think when people hear about stagflation, it's bad growth and inflation probably 6%, 7%, 8%, something like that, and that's really not the situation we're in right now.

KATHY: I would say my threshold for measuring it as stagflation would likely be, you know, 5% inflation that persisted for a while, in concert with slowing economic growth, maybe a recession, rising unemployment. That's kind of the worst-case scenario. And that's not like the '70s. We had higher inflation and even worse growth. I would agree "stagflation" gets thrown around as a term that, you know, maybe a little too easily.

But one of the things I think that is troubling in this environment is, OK, so let's say we get into that situation. Tariffs are high. We're seeing inflation tick up. We're seeing unemployment tick up. The Fed decides to ease. What problem does that solve? As you said, we have a trade problem, which can produce a supply-side shock, but I'm not sure that cutting interest rates is going to solve the problem. And that's where you run into the question marks. OK, they need to do something if the economy's really slowing and slipping into recession, but how much good can they do by just cutting rates? We would still see probably supply shortages, higher prices for certain goods. I guess you'd really run the risk of recession, which is what they try to avoid, but it's not like we have a good tool to deal with a supply-side shock. found that in the pandemic. We didn't have good tools for it then, and we don't have great tools for it now if it's caused by tariffs, except to repeal the tariffs or figure them out. So it's a tough spot for the Fed. 

Let's move on since the Fed didn't do anything. Let's move on a little bit to the market reaction. I thought it was interesting. We got an initial reaction, bonds rally and then the kind of petered out came back a little bit lower in the longer end, a little bit higher on the short end—that might have been positioned for a more dovish message. But what do you think this does for the markets between now and the next meeting?

COLLIN: Not too much. I can say I'm a little surprised by the market reaction, but it's so minuscule relative to what we've seen in the past. We're talking about a few basis points here and there. If we look at the two-year Treasury yield, it dropped, it increased, and it kind of ended exactly where it was, which I think that makes a lot of sense. They didn't make a change, and Powell said they're in no rush. So I feel like we shouldn't have expected a noticeable move in either direction.

Long-term yields are down a little bit, and I think that might just stem from the idea that risks to both of their mandates have risen, and the economic outlook is so uncertain right now. Now, there has been a lot of volatility. The bond market's acted a little bit weird in early April, despite the tariff announcements and despite stock market declines and volatility. Treasuries initially served as the diversifier that we expected them to be, but then we saw yields increase for any number of reasons I think you could make the case for. But I still am in the camp that if we get a truly uncertain market environment, and if we do get slower economic growth—and hopefully not, if that dreaded R word, the recession, arrives—I think you'd see lower long-term yields. So I think that's probably a key driver there, but it's going to depend on the data. 

The incoming data over the next few weeks and months is going to be very important because we're finally going to start getting the post-tariff announcement numbers. We already got one from the April jobs report, but that was just a week and a half or so after the announcement. I don't know how much that's going to capture. The next few weeks and months are going to be really important. And I think we'll see the markets react to that. If we start to see that the data is holding up well, the hard data, then I think we could see yields drift up a little bit and expectations that the Fed doesn't need to cut as aggressively as the markets initially expected. 

And the flip side, I think, is also true. If we start to see, uh-oh, this data is actually a bit disappointing, matching the disappointing soft data we've got, then I think we'd probably see long-term yields actually trend a little bit lower.

KATHY: Yeah, I would agree. I think longer term, the curve steepens because I would expect the Fed to cut rates in response to slowing economy. If tariffs persist, we'll see it. We're already hearing about the Port of Los Angeles activity is down 50% already. They estimate in another week it'll be down 75%. So those shortages of supplies are already going to show up very quickly.

And when you have a shortage of materials to run your business, then you start laying people off or cutting hours, and it accumulates. So some of that's already in transit. And so, yeah, I feel like we're going to see the Fed have to respond to it, but maybe not until fall. 

But I wanted to shift gears a little bit to the corporate bond market because that gets involved with what happens to companies that are trying to run their business in an environment that's highly uncertain. And so far, we've seen a little bit of widening in credit spreads, a little bit of effect, but it's been pretty stable. So if indeed we see a slower economy, do you expect the spreads to widen?

COLLIN: I would expect that yes. And when we're talking about spreads, we're talking about the extra yields that a corporate bond offers relative to a comparable Treasury. It's meant to compensate, you know, us as investors for the risks involved. If economic growth were to slow—as we think it will; you know, the magnitude of that that slowdown, I think, is up for debate—but I do think it should slow given all the uncertainty. That's a negative for corporations because it means fewer, likely fewer … less money coming in, revenues down, profits down, in an environment where interest rates are still, you can call them high relative to where they've been over the past 15 years. So if earnings are down, but you have to keep maintaining that same interest expense, that's a bad combination. 

And we've started to see some weakness there over the past few years, both with investment-grade and high-yield issuers, so high-yield issuers are those with sub-investment-grade credit ratings. But we've seen the ratio of earnings to their interest expense come down. So if we got an economic slowdown, we'd probably see that come down even more, and there'd probably be a number of companies that have low ratings and have a lot of debt on hand that might begin to struggle more being on time with their interest payments or repaying principal. So all that being said, I think that spreads could move a little bit higher from here, meaning there could be a better opportunity for investors to invest at some point down the road. There's also a caveat there for current bondholders. If you're a bondholder in high-yield bonds now, and spreads rise, spread's a function of yield, and bond prices and yields move in opposite directions. So if spreads rise, that means that the value of those bonds are likely to fall as well. Now that might not matter if you're a buy-and-hold investor, and over time prices can kind of rebalance, but in the short run, rising spreads can pull prices down a little bit. If you're a long-term investor, we're OK taking a little risk. As you mentioned, Kathy, spreads are up a little bit from the 2025 lows we saw in January and February, and they're still below the long-term average, but they're higher than they were recently. So it's gotten a little bit more attractive to invest, but not at a level that we think it makes sense for most investors.

If you're willing to take a little risk, and you can ride out some ups and downs, you can consider high-yield bonds in moderation, but we think there might be better entry points down the road.

KATHY: Yeah, I'm a little concerned about credit quality deteriorating just because it was so good. We're starting with such a good level with earnings growing, and interest expense was not rising, and it seemed like kind of a perfect world, and now we're entering a period where we really don't know. I think the market's trying to assess which companies, which industries, will be affected the most and how that will play out, but again, caught in that. I've been impressed by how solid the market's been, given all the uncertainty and the volatility in the stock market. 

One area though that I will call out that has been quite volatile and has moved a lot since all this began is the foreign-exchange market. So we've seen a big drop in the dollar, and I think prior to the announcement of tariffs, the dollar versus the euro was around, euro was under 110 versus the dollar. Now it's almost 114, which percentage-wise is a pretty big move. We've seen some high volatility in some of the Asian currencies with big exposure to U.S. dollars. So there's been a lot of activity there. And I often look at the foreign-exchange market as kind of the canary in the coal mine.

It reacts very, very quickly. And so I'm a little concerned that as we go forward into the summer, this level of volatility could transfer from the foreign-exchange market to the bond market. But that remains to be seen, and I don't expect it to have a huge, huge impact. But it does make me concerned that we're kind of poised for more volatility than today's response to the Fed meeting might imply. 

But one market that has been very attractive to us for a while, municipal bonds. And I know this is not your area specialty—it's Cooper Howard's—but I have to put in my public service announcement that there's been a lot of dislocation in the municipal bond market. It tends to lag in reaction because it's mostly … most of the investors are individual investors who tend to not move around as quickly as institutional investors, and so … and a lot of buy-and-hold investors. So market doesn't necessarily reflect changing conditions, but what we're looking at is very attractive tax-adjusted, tax-equivalent yields for people in high tax brackets, so I think that's been one market that, because it tends to lag, can offer up some opportunities. 

I guess the biggest risk there is that the effort to cut spending at the federal level have an impact on state and local governments. Now, it shouldn't in general be a big problem, but when you start to see talk about cuts to things like disaster relief, then you look at communities that are sort of subject to big events, hurricanes, earthquakes, any place, even places that never used to have climate disasters have had them recently. So you start to worry about their ability to cope with that. But I think that that's just a very high-level, long-term risk, and I seriously doubt Congress is going to pull away disaster relief because Congress is made up of people in local districts. Then when the disaster hits, they want that federal relief. But that's probably the biggest worry I have in that market. But any other, any thoughts on what, you know, if you're a bond investor, any thoughts on what you'd be thinking about doing right now?

COLLIN: Well, I think I want to build on your municipal bond points. As you alluded to, anything I'm saying, I'm getting from our colleague Cooper. He's doing all the work on this. But he's had some really great insights on that market lately. And I'll kind of expand on them a little bit. We've got a lot more volatility there relative to Treasuries and corporates since the tariffs were announced. And I think a lot of that comes down to the relative illiquidity of the market versus corporates and Treasuries.

I don't think the price declines are due to credit quality concerns, maybe to a degree for the points you made, but more due to a general illiquidity. From a credit-quality standpoint, we think that it's probably peaked in terms of how good are the fundamentals of these municipalities looking, or are they going to look? That's probably peaked, but we don't expect it to get much worse anytime soon because they're starting from a pretty strong starting point.

And just in general, investment-grade munis have very high credit ratings. I mean, about two thirds of the investment-grade municipal bond index are rated AAA and AA, the two highest rungs of the investment-grade credit rating. And if you compare that to corporates, the investment grade corporate index that I track, most of it, about 90% or more, is single A and BBB, so the bottom two rungs of the investment-grade credit spectrum. So you see much higher ratings with munis. And because of the dislocations we've seen over the past few weeks, we've seen muni yields rise to levels where they are just very, very attractive relative to Treasuries and corporates when we're considering taxable accounts. And I think that's the key point to make. You always want to figure out which account you're placing these in. Are they in a taxable or tax-advantaged account? But for a taxable account, munis are very attractive relative to those alternatives, and not just to the highest income earners. It's not just those investors that are in the highest tax brackets. We can see people with tax brackets or marginal effective tax rates in the mid-20s, which … where munis would still make sense. And think that probably catches a lot of people off guard. You think that "Oh, munis are just for the wealthiest out there," but that's not the case. They can make a lot of sense for a lot of investors today.

KATHY: Yeah, I would agree. It's been kind of one of my pound-the-table topics lately when I'm out there speaking to either reporters or to clients. So any last parting thoughts before we move on to the next big event in the market, which could be anything in the next 10 minutes?

COLLIN: Parting thoughts would be, focus on the income and yield that bonds offer. I think there's a lot of questions. We've gotten a lot of questions and concerns from clients, given all the market volatility, but remember what bonds do. They provide income. And over time, most of your return from a bond is going to come from income payments as opposed to price fluctuations. And the starting yield that an investment offers, whether it's a portfolio of individual bonds that you might own, or a mutual fund or ETF, that starting yield is a pretty good indicator of what the annualized average return could be if you're holding that investment over time, if you're focusing on highly rated investments, because the likelihood of default is lower there. So focus on that yield, and if you can get high-quality investments yielding 4% or more, and if that can help you reach your goals, I think that's something to focus on.

Not that you can totally ignore the noise out there, but if you're going to hold for a period of time, and that yield looks attractive, I don't think you should be scared of the bond market today.

KATHY: Yeah, I would 100% agree. There's a lot of nervousness out there, but I think if you're in high-quality bonds, you can kind of put that aside and just focus on the income. Well, thanks a lot, Collin. See you soon.

COLLIN: Thank you for having me.

LIZ ANN: All right, so Kathy, it's our time on these episodes to look ahead. So what are you keeping an eye on in terms of the end of this week and next week's indicators?

KATHY: Well, for me, the top three would be the Consumer Price Index, CPI, the Producer Price Index, PPI, and retail sales. Obvious reasons, the inflation readings are so important right now in terms of setting policy and expectations for bond yields going forward. And then retail sales, you know, get a view of what the consumer is doing, not just what they're saying. That's going to be interesting for me as well in terms of assessing where the economy goes since the consumer basically drives the economy. What about you, Liz Ann? What do you think investors should be paying attention to?

LIZ ANN: Totally agree with you on the inflation and the retail sales data. We also get some housing data out next week as well. Housing starts, building permits—building permits is a key leading indicator—and then both import and export prices, maybe not necessarily indicators we ever pay close attention to outside the confines of a trade war, but I'll remind everybody we're in one. So those could have some interesting tidbits. And then we get, we talked about consumer confidence that comes out from the Conference Board at the end of next week, we get University of Michigan's version of that, which they call consumer sentiment. And that has a lot of components to it as well. So that's what's on my radar.

So that's it for us this week. Thanks as always for listening. You can always keep up with us in real time on social media. We both post regularly on both X and LinkedIn. I'm @LizAnnSonders on X and LinkedIn. Still lots of imposters, so make sure you're following the real me.

KATHY: And I'm @KathyJones—that's Kathy with a K—on X and LinkedIn, also with a handful of imposters. Usually they just spell the name wrong, so you can tell. And you can always read all of our written reports, including charts and graphs, at schwab.com/learn.

LIZ ANN: And if you've enjoyed this episode, we'd be so grateful if you'd leave us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen, and we will be back with another episode next week.

For important disclosures, see the show notes or visit schwab.com/OnInvesting, where you can also find the transcript.