Fed’s trouble with tariffs
The Federal Reserve’s challenges concerning tariffs. The complexities of tariffs and public perception of prices holds significant weight for the Federal Reserve. Federal Reserve officials meticulously observe inflation expectations, derived from consumer surveys as well as market-based indicators. A pivotal inquiry confronts the Federal Reserve as President Trump considers more aggressive applications of tariffs in a potential second term: To what extent would any resultant price hikes stoke public expectations of rising inflation?
The Federal Reserve is anticipated to maintain its benchmark interest rate during the two-day meeting that wraps up on Wednesday, pausing after a series of three consecutive cuts totaling one percentage point in short-term rates. Since officials initiated rate cuts in September, inflation has exhibited inconsistent movement towards the central bank’s target of 2%. The labor market has shown consistent growth, alleviating concerns of an abrupt downturn that emerged last summer.
The decision of the Federal Reserve to resume interest rate cuts hinges significantly on the inflation outlook, which may be influenced this year by Trump’s potential implementation of tariff increases. Last week, Trump indicated that he was contemplating the imposition of increased tariffs on imports from Canada and Mexico by this Saturday. Tariffs continue to represent a significant variable in the Federal Reserve’s projections, primarily due to apprehensions regarding their potential impact on the inflation expectations of both businesses and consumers.
Indeed, the Federal Reserve ultimately reduced interest rates in 2019, coinciding with the escalation of a trade conflict during Trump’s initial presidential term. Federal Reserve Chair Jerome Powell and his associates expressed concerns that the adverse impact on business sentiment and investment stemming from a trade conflict could overshadow the potential consequences of increased prices due to tariffs. A television station transmitting December comments from Federal Reserve Chair Jerome Powell directly to the trading floor of the New York Stock Exchange.
The tariffs in question were modest in scale. “To the extent they influenced economic activity, they were not inflationary because that was not an inflationary period,” stated Steven Kamin, who previously managed the Fed’s international finance division and is currently affiliated with the American Enterprise Institute. The Federal Reserve is expected to respond distinctively this time following the implementation of any tariff hikes, given that the United States has recently experienced a significant inflationary period.
“Price setters and price payers exhibit a heightened sensitivity to price pressures compared to their stance in 2018,” remarked Kamin. He indicated that the Fed is likely to adopt a more cautious stance towards tariff hikes in this instance compared to previous episodes, maintaining elevated interest rates if such increases are implemented. Kamin noted that the Federal Reserve rarely adjusts interest rates in response to anticipated policy outcomes, suggesting that any reaction is improbable until the effects of tariff increases become evident.
Federal Reserve officials are vigilant in tracking inflation expectations, derived from consumer surveys and market indicators. As Cleveland Fed President Beth Hammack articulated in a recent interview, “if people expect inflation to be higher, they will respond and react differently, in a way that will drive more inflation.” Should landlords anticipate a rise in their expenses, they are likely to increase rents preemptively to mitigate the impact of forthcoming cost escalations. Employees are poised to advocate for increased wage increments.
A recent survey conducted by the University of Michigan revealed a slight increase in inflation expectations following the November election. Researchers conducting the survey noted that consumers persistently articulated their intent to purchase cars and other durable goods at present to preempt potential price hikes in the future. Recent months have seen a modest increase in investors’ expectations for inflation over the next one to two years, despite the relative stability of longer-term expectations, as indicated by metrics like the two-year inflation break-even rate.
During Trump’s previous presidency, when tariffs were levied on trading partners, the outlook for future inflation remained subdued and securely anchored, akin to being set in dry cement. The general populace possessed limited familiarity with inflation, resulting in a greater reluctance among businesses to transfer the burden of tariff-induced price hikes to consumers. “They were unaware of the potential loss in business” that could result from a price increase, stated Hammack.
However, multiple years of elevated inflation, instigated by the pandemic alongside a policy response characterized by exceptionally low interest rates and substantial fiscal stimulus, have prompted scrutiny regarding the Federal Reserve’s capacity to maintain a nonchalant stance towards rising prices. Should the cement remain damp, anticipations of elevated inflation in the future may underpin continued price escalation. Corporate management teams, having navigated the challenge of escalating costs, now possess a newfound capability to implement price increases that was absent five years prior. Domestic producers not directly affected by tariffs may exploit elevated import prices as a rationale for increasing their own pricing structures.
“There is a growing tolerance for rising prices in light of recent experiences,” remarked Hammack. Scott Bessent, confirmed on Monday as Trump’s Treasury secretary, minimized the likelihood of increased consumer prices resulting from tariffs during his confirmation hearing earlier this month. The dollar may appreciate against foreign currencies, mitigating some of the heightened expenses for U.S. importers. Concurrently, foreign manufacturers might reduce prices, and consumers could adjust their purchasing habits to circumvent any residual cost increases.
Scott Bessent, spectacles perched on his nose, made his entrance at President Trump’s inauguration earlier this month. The significance of expectations in the Federal Reserve’s perspective on the inflationary process implies that the manner in which tariff hikes are executed may influence the decisions made by officials regarding interest rate adjustments. In 2018, Kamin and fellow economists at the Federal Reserve analyzed the ramifications of a tariff hike, determining that the central bank could overlook elevated inflation indicators provided two criteria were met: households and businesses anticipated low inflation, and the price escalations permeated the economy swiftly.
“Should all actions be executed simultaneously and not repeated thereafter, they would merely result in a transient elevation of the price level.” “You would observe a surge in inflation, which would subsequently dissipate,” remarked Fed governor Christopher Waller during a Q&A session at a conference in Europe earlier this month. However, should tariff increases be implemented at staggered intervals across various nations and on a diverse array of goods, it may complicate the Federal Reserve’s ability to discern whether price escalations are attributable to tariffs or if they stem from wider macroeconomic dynamics.
“Will this be a singular event, or are we looking at a protracted series of tariffs spanning various sectors of the economy over the next two years?” In a recent interview, Alberto Musalem, President of the St. Louis Fed, shared his insights. “Should the duration exceed two years, the task of discerning becomes progressively more challenging on a monthly or bi-monthly basis.” To grasp the apprehension of Fed officials regarding the potential jeopardization of inflation expectations, one must examine the forecasts they issued in December. During their most recent gathering, officials forecasted that core inflation is expected to decrease to 2%, down from approximately 2.8% at the close of the previous year, over the forthcoming two years, even in the context of sustained economic activity and minimal slack—characterized by unemployed labor and unused industrial capacity—in the economy.
According to models from the Federal Reserve, the presence of long-term inflation expectations firmly established at a low level will exert a significant influence on inflation dynamics. As individuals determine wages and prices, this anchoring effect is anticipated to be sufficient to draw actual inflation down to the target rate of 2%, as articulated by William English, a former senior adviser to the Fed. A potential concern for the Federal Reserve is that, as noted by English, a professor at Yale School of Management, “in practice, it doesn’t really work.” Should inflation remain nearer to 3% rather than 2%, it is probable that Federal Reserve officials will determine the necessity of maintaining elevated interest rates for an extended period to induce greater economic weakness, thereby facilitating a reduction in prices.
