Inflation, slowing worries caused by tariffs plague Fed
Federal Reserve officials find themselves navigating the complexities of inflationary pressures while grappling with concerns over economic deceleration in the context of tariffs. The US economy exhibits overall resilience; however, this does not alleviate the concerns faced by Federal Reserve chair Jerome Powell. As the Federal Reserve deliberates its forthcoming actions in a two-day meeting this week, the majority of economic indicators appear robust: Inflation has been gradually diminishing, whereas the unemployment rate remains at a historically low 4.2%. President Donald Trump’s widespread tariffs may lead to an increase in inflation in the coming months, while also potentially hindering growth.
Given the prevailing uncertainty in the economic landscape, it is anticipated that Federal Reserve policymakers will maintain the current key interest rate at approximately 4.4% during their meeting on Wednesday. Officials are set to unveil a series of quarterly economic projections anticipated to indicate an uptick in inflation later this year, alongside a potential slight increase in unemployment rates. Economists suggest that the projections may indicate the Fed is likely to implement two cuts to its key rate later this year.
The expectation of increased inflation generally prompts the Federal Reserve to maintain or potentially elevate interest rates, whereas a rise in unemployment typically results in the Fed reducing its primary rate. As the economy exhibits signs of dual potential trajectories, Powell and other Federal Reserve officials have emphasized in their recent statements a willingness to remain patient for more definitive indicators regarding the appropriate course of action.
The Federal Reserve finds itself in a challenging state of limbo, remarked Diane Swonk, chief economist at the accounting firm KPMG. Absent the prospect of tariffs, we would likely observe a reduction in the Fed’s rates. That is not the current situation due to the prevailing uncertainty, the associated threats, and the yet-to-be-determined effects of tariffs. The Trump administration has significantly intensified its demands on Powell to lower borrowing costs, with Trump labeling the Fed chair a numbskull for his reluctance to cut rates. Other officials, such as Vice President JD Vance and Commerce Secretary Howard Lutnick, have similarly advocated for a reduction in rates.
When the Federal Reserve lowers its primary short-term interest rate, it frequently, though not invariably, results in decreased expenses for consumer and business borrowing, encompassing mortgages, auto loans, and credit cards. However, financial markets exert an influence on the levels of longer-term rates, potentially maintaining them at elevated levels even in the event that the Fed lowers the shorter-term rate it governs. For instance, should investors express concerns regarding persistently high inflation, they may require increased interest rates on longer-term Treasury securities, thereby affecting other borrowing costs.
While Trump has asserted that the economy is performing adequately, he has simultaneously contended that a reduction in interest rates would propel the economy forward with remarkable speed. However, Trump has underscored an additional issue: Should the Fed refrain from reducing rates, the federal government will face increased interest payments on its substantial budget deficits, which are anticipated to expand further under the tax and budget proposals currently under Senate review. “We’re going to spend $600 billion a year, $600 billion because of one numbskull that sits here and says, I don’t see enough reason to cut the rates now,” Trump stated last week.
Pushing the Fed to cut rates merely to alleviate the government’s interest payment burden often raises concerns among economists, as it could jeopardize the Fed’s congressional mandate to prioritize stable prices and maximum employment. Despite Trump’s recent criticisms of the Federal Reserve, market reactions have been muted, particularly following last month’s Supreme Court ruling indicating that a president lacks the legal authority to dismiss the Fed chair.
Nonetheless, with inflation persistently low thus far, despite the implementation of tariffs, the Federal Reserve may face increasing pressure in the upcoming months from economists and investors to reduce interest rates. Policymakers estimate that the interest rate, which would neither stimulate the economy nor slow it down, known as the neutral rate, is approximately 3%. Meanwhile, inflation, as indicated by the Fed’s preferred measure, stands at 2.1%, nearing the central bank’s target of 2%. This low reading indicates that the Fed’s rate ought to align more closely with neutral, falling below the existing level of 4.4%, as a high rate is unnecessary to curb inflation.
“It’s a reasonable case for the Fed to grapple with,” stated Jon Hilsenrath, a visiting scholar at Duke University. According to a survey conducted by Hilsenrath for Duke, former Fed officials and staff anticipate that the Fed will implement a single interest rate cut this year. There exists a potential for inflation to rise, and they are cautious about acting prematurely, he stated. It appears that tariffs might not elevate inflation to the extent that many analysts have anticipated. One potential explanation for this phenomenon is that an economic slowdown could lead to increased unemployment, resulting in consumers being less inclined to accept higher prices, thereby contributing to a reduction in inflation.
Analysts at Goldman Sachs indicated in a recent research note their expectation that inflation will reach 3.6% by December, although they believe this increase will be temporary. The primary rationale for our diminished concern is our anticipation of a weak economy this year, accompanied by… a modest increase in the unemployment rate. Jan Hatzius, chief economist at Goldman, along with his colleagues, articulated.
A discernible deterioration in economic conditions that dampens consumer expenditure and restrains inflation would probably prompt the Federal Reserve to promptly reduce interest rates. However, they will feel more at ease proceeding once they have a clearer understanding of the comprehensive effects of tariffs. Michael Gapen, chief US economist at Morgan Stanley, noted on Monday that the Federal Reserve will require several months to evaluate the impacts of policy adjustments, asserting that a delayed but accurate approach is preferable to an expedited yet erroneous one.
