Higher inflation likely to delay - not derail - Fed easing

Key Takeaways

• With inflation likely to rise due to higher energy prices, we expect the Fed's easing cycle to slow.
• Bond yields have moved higher, driven in part by expectations for delayed rate cuts and rising inflation.
• Municipal bond yields have risen as well, potentially offering attractive after-tax income for investors in top tax brackets.
• Higher yields improve income potential, the primary driver of bond returns.

Fed easing delayed, not derailed 

The Fed held its policy rate steady for a second consecutive meeting in March and updated its quarterly projections. The expected path for the Fed funds rate was unchanged, still signaling one cut this year followed by another next year. The central bank raised its inflation outlook for 2026 and 2027, citing the temporary effects of higher oil prices and lingering tariffs. At the same time, it upgraded its growth estimate on expectations for stronger productivity. While the "dot plot" still points to one cut this year, some participants shifted from expecting two or more cuts in the December forecast to just one, suggesting that the center of gravity has moved modestly less dovish. Bond markets may be reflecting that nuance, pricing in a slower pace of easing ahead, shown in the chart below.

We still think the Fed remains in its easing cycle, though that path now appears more gradual, likely pointing to one cut later this year. The central bank's preferred inflation gauge, the Personal Consumption Expenditures (PCE) price index, was running at 2.8% through January and has remained above the 2% target for five years now. Meanwhile, a stabilizing labor market — marked by slower hiring and fewer layoffs — may give policymakers more time to assess whether inflation is cooling, rather than forcing more urgent action. Importantly, policymakers still see inflation returning to target by 2028, reflecting the view that the expected rise will not be persistent enough to require a renewed tightening cycle. In our view, the Fed is likely willing to look through this temporary increase, provided longer-term inflation expectations remain anchored.

Bond yields have risen but are likely to remain range-bound 

Bond yields have risen from their February lows, bringing the 10-year Treasury yield back more firmly within our expected 4.0%-4.5% range. The prospect of delayed Fed rate cuts has accounted for most of that move, pushing the entire yield curve higher. Inflation expectations — a key component of bond yields — have also contributed.

Continued Fed purchases of Treasury bills should help anchor the short end of the yield curve near the fed funds rate, limiting upward pressure on yields. Conversely, resilient economic growth, persistent fiscal deficits, and inflation risks typically drive yields higher, making a sustained drop unlikely, in our view. Although bonds often benefit during periods of market stress, they can be vulnerable to inflationary shocks. On a positive note, higher yields improve income potential, the primary driver of bond returns. In addition, any easing in inflation expectations could lift bond prices, which move inversely to yields.

Municipal bonds can offer compelling after-tax income 

Municipal (muni) bond yields have moved higher alongside taxable bond yields, potentially presenting a more attractive entry point for investors in higher income tax brackets. Because interest on most muni bonds is exempt from federal income tax — and, in some cases, from state and local taxes when issued in an investor's home state — their income advantage can be meaningful, particularly when held in taxable accounts. For high earners, a key benefit may be less about the stated yield and more about how much income they keep after taxes. As a result, muni bonds can provide a compelling combination of tax efficiency, credit quality and diversification, especially when after-tax income is a priority.

A useful way to compare tax-exempt munis with taxable bonds is through the tax-equivalent yield, calculated as: tax-exempt yield ÷ (1 - marginal federal income tax rate). This estimates the yield a fully taxable bond or fund would need to offer to match the after-tax income of a tax-exempt muni bond or fund. As the chart below shows, the value of that tax exemption grows as the investor's marginal tax bracket rises.

Finally, the muni bond market can be sensitive to changes in supply of new bonds, so any slowdown in bond issuance due to higher yields could support prices by helping to keep supply in check.

^{Source for all data not cited: FactSet as of the date of this report, unless otherwise noted.}