Rising inflation expectations could put Fed on shallower rate-cut path

(Reuters) -American families are growing sharply less optimistic about the economic outlook, but the Federal Reserve may be loathe to respond aggressively to a weakening economy in light of increasing worries that the Trump administration's trade policy will boost already elevated inflation.

That's the betting reflected in financial markets on Friday, as the widely watched University of Michigan survey showed consumer sentiment plunged in March and consumers saw inflation over the next five years running at 3.9%, the highest reading in more than 30 years.

Pricing of short-term interest-rate futures still reflects an expectation for a June start to Fed rate cuts, with likelier than not a total of three quarter-point reductions by the end of the year.

But the probability of a third rate cut, in December, has eroded as financial markets digest the dueling implications of worsening consumer confidence, which can portend slower growth, and higher inflation expectations, which can portend higher actual inflation. 

Fed policymakers have said they will respond if the unemployment rate rises unexpectedly, but they also say they need to see more progress on inflation and have their eyes fixed squarely on inflation expectations as an added upward risk.

"Don’t hold your breath for the Fed to ride to the rescue if spending falls as inflation expectations are soaring," wrote Comerica economist Bill Adams. 

Fed policymakers are universally expected to leave rates in their current 4.25%-4.50% range when they meet next week, and traders are also betting against a rate cut at their May meeting.

Investors will pay particularly close attention to the Fed's own projections for inflation, unemployment and the path of rates, due to be published March 18 at the end of their two-day policy-setting meeting. In December Fed policymakers forecast two interest-rate cuts this year.

Since then, an ebullient stock market has given way to discouragement, with U.S. stocks losing $6 trillion in value in the last three weeks as Trump has doubled tariffs on China, said he will put 25% tariffs on Mexican and Canadian goods starting April 2, drawing retaliatory tariffs from trading partners.

(Reporting by Ann Saphir, Editing by Nick Zieminski)