ANALYSIS-Fed's rate cut comes with caveats, leaving investors lukewarm

Fed tempers dovish tilt as inflation remains sticky Investors cautious on risk assets amid stagflation threat Market reaction muted to first rate cut since December Disagreement within Fed expected to add to volatility By Davide Barbuscia and Suzanne McGee NEW YORK, Sept 18 (Reuters) - Investors look set to face a volatile few months ahead after the Federal Reserve resumed interest rate cuts and opened the door to further easing but tempered its message with warnings of sticky inflation, sowing doubt over the pace of future policy adjustments. Some investors are now less certain that a rapid shift to lower borrowing costs will materialize, potentially dampening optimism that stocks and bonds would get a strong lift from easier policy. Adding to the uncertainty was a wide variety of views within the Fed on the future path of rates. “We’ve had a rather cautious, not necessarily fully defensive… view here for a while,” which was “reinforced” by the Fed’s message, said Larry Hatheway, global investment strategist at the Franklin Templeton Institute. Hatheway added that many in the market would likely be slightly disappointed at the lack of clarity and direction from the Fed, which stopped short of endorsing market expectations for a clear string of rate cuts, emphasizing a meeting-by-meeting, data-dependent approach. At Wednesday’s meeting, the Fed lowered its policy rate by 25 basis points to a range of 4%-4.25%, its first cut since December, and signaled a gradual easing cycle in response to mounting labor market concerns. At the same time, Fed Chair Jerome Powell highlighted “a challenging situation” for policymakers, noting that risks to inflation were tilted to the upside and risks to employment to the downside. The comments dampened market optimism despite a much hoped-for dovish shift after recent data that showed unemployment climbing to 4.3% in August and payrolls growing far less than expected. A steep downward revision to benchmark jobs figures for the year through March also recently added weight to the view that the labor market is losing steam, bolstering the case for multiple rate cuts ahead. The U.S. central bank’s release on Wednesday of updated quarterly economic projections, including rate forecasts issued in a chart known as the “dot plot”, reflected expectations of more easing this year when compared to the ‘dots’ from the June meeting, with 50 basis points in cuts seen before year end. At the same time, the Fed’s projections still put inflation ending this year at 3%, well above the central bank’s 2% target, while its projection for economic growth was slightly higher at 1.6% versus 1.4%. “Markets may welcome the easing bias, but the messaging remains nuanced and far from a full pivot,” said Dan Siluk, head of global short duration and liquidity, and a portfolio manager at Janus Henderson Investors. The Nasdaq and the S&P 500 had gone into the meeting close to record highs, but closed lower in choppy trading on Wednesday. Treasury yields, which move inversely to bond prices, rose, with two-year yields up four basis points on the day at 3.55% and benchmark 10-year yields up by about seven basis points to 4.09%. The yield curve had been flattening in recent weeks, with the gap between long-dated and short-dated yields decreasing on expectations of rate cuts. “The Fed is in a tough spot,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “They expect stagflation, or higher inflation and a weaker labor market. That is not a great environment for financial assets.” STAGFLATION RISKS LINGER U.S. consumer prices increased by the most in seven months in August amid higher costs for housing and food, resulting in the biggest year-on-year increase in inflation since January. Combined with softening labor market conditions, higher inflation has sparked fears of stagflation - a worrying mix of sluggish growth and high inflation that haunted the U.S. in the 1970s and that could complicate the Fed’s ability to support the jobs market with hefty rate cuts. “This is far from the stagflation of the 1970s, but at the margin argues for a more conservative outlook for returns on stocks and bonds,” said Michael Rosen, chief investment officer at Angeles Investments. The Fed’s shift to easing on Wednesday was also being scrutinized after relentless pressure from U.S. President Donald Trump’s administration on the Fed to cut rates. Stephen Miran, Trump’s nominee and economic adviser, was sworn in to the Fed’s Board of Governors on Tuesday and registered the lone dissent to the Fed’s quarter-point cut decision, instead arguing for a bigger half-point reduction. Markets were also left to contend with the Fed’s ‘dot plot’ showing a wide variety of forecasts, with one participant penciling in a 4.4% year-end rate, above the new 4.00%–4.25% range. At the other end, one policymaker marked down a year-end policy rate of 2.9%. “I think the market was having trouble digesting all the information they got. Certainly, it did not give anyone a tremendous line of sight” into how Fed policymakers are approaching decision-making, said Josh Hirt, senior U.S. economist at Vanguard. “There is such disagreement amongst the committee members that there is some heightened uncertainty,” Hirt added, and greater volatility “is one potential consequence of this increased number of different cross currents.” Where policymakers expect to steer interest rates