MARCH 20, 2025
Stocks rose after the Fed held interest rates steady Wednesday. – Angela Weiss/AFP/Getty Images
The Federal Reserve’s first set of projections since Donald Trump’s inauguration underscored—in the central bank’s understated and technocratic fashion—just how much the president’s plans to press ahead with widespread tariffs have turned the economic outlook on its head.
Months ago, policymakers presumed they would spend 2025 gradually cutting rates to keep inflation heading down without a big rise in joblessness to achieve the so-called soft landing. The latest projections point to the prospect that tariffs covering a swath of goods and materials will send up prices while sapping investment, sentiment and growth, at least in the short run.
“We now have inflation coming in from an exogenous source, but the underlying inflationary picture before that was basically 2½% inflation, 2% growth and 4% unemployment,” said Fed Chair Jerome Powell on Wednesday.
Officials projected weaker growth, higher unemployment and higher inflation than they had anticipated in December. Moreover, nearly all officials judged that if their forecasts were to be proven wrong, it would be in the direction of even softer growth, more joblessness and firmer price growth.
A combination of stagnant growth and higher prices, sometimes called stagflation, could make it harder for the Fed to cut interest rates this year to pre-empt any slowdown.
“You’re looking at a whiff of stagflation,” said Jay Bryson, chief economist at Wells Fargo. “I say stagflation with a small ‘s,’ not a capital ‘S.’ Those of us who are old enough to remember the late ’70s and early ’80s—this is not the stagflation of those years.”
Stocks rallied because a majority of officials penciled in two rate cuts for this year, the same as in December. Powell held out, with low conviction, the prospect that “tariff inflation” might not demand any meaningful change in the Fed’s interest-rate posture.
On Wednesday night, President Trump said he wanted to see borrowing costs lowered. “The Fed would be MUCH better off CUTTING RATES as U.S. Tariffs start to transition (ease!) their way into the economy. Do the right thing,” he wrote in a social-media post.
There are signs the interest-rate outlook is shifting away from cuts in the near term, something investors have been slow to appreciate. The number of officials who penciled in fewer cuts compared with December went up. And Powell conceded that a “highly uncertain environment” led some officials to simply not fuss over big changes to the rate outlook. “There is a level of inertia where you just say, maybe I’ll stay where I am,” he said.
If the Fed has to make tricky judgment calls, they are likely to be guided by two episodes from the Powell Fed’s recent past that offer contrasting lessons.
In 2019, Trump was dialing up tariffs against China. But Fed officials judged that the hit to business confidence and investment was likely to overwhelm any inflationary impetus from rising prices on imported goods. Inflation had mostly run below the Fed’s 2% goal, and they believed any tariff-related price hikes would be a one-time event. They ended up cutting rates.
In 2021, the economy was reopening from the pandemic, and inflation took off. But Fed officials believed that cost pressures from supply shocks would quickly resolve—the now-infamous “transitory” inflation. They later had to make a U-turn, raising rates at the fastest pace in four decades to fight inflation that hit a 40-year high.
On Wednesday, Powell allowed for the possibility that such a “transitory” diagnosis could be appropriate “in the case of tariff inflation.”
Compared with those earlier episodes, “It’s a different situation,” he said. “We haven’t had real price stability fully re-established yet, and we have to keep that in mind,” he added.
Negative supply shocks
At issue is how central banks should navigate a negative supply shock—for example, a surge in oil prices. Negative supply shocks limit the ability of the economy to produce goods or services. Prices suddenly rise for some producers but are offset by lower inflation-adjusted incomes that weigh on overall economic growth.
Standard monetary policy theory says if these shocks are expected to raise prices on affected goods as a one-time hit, policymakers should “look through” the shock—in other words, don’t do anything different from what you were planning to do with interest rates before the shock hit.
But that is easier in theory than in practice. “The economy is much more complex, with lots of little feedback loops,” said Donald Kohn, a former Fed vice chair. “You have to figure out how much is transitory and how much is likely to be perpetuated by these second-round effects, and there is no clean way of doing that.”
Officials could be hard-pressed to declare price increases from tariffs as temporary if they set in motion a reordering of global production processes that takes years to play out.
On top of that, Fed officials are nervous that the postpandemic inflation might have given businesses and consumers more acceptance of higher inflation. Policymakers pay close attention to expectations of future inflation because they think those expectations can be self-fulfilling.
A combination of stagnant growth and higher prices, sometimes called stagflation, could make it harder for the Fed to cut interest rates this year to pre-empt any slowdown. – Richard B. Levine/Zuma Press
“I think that’s the bottom line for why this isn’t going to be viewed as a one-time transitory shock. Inflation has been above its target for four years, and we now have a situation where, once again, we are going to see price-level changes,” said Eric Rosengren, who was president of the Boston Fed from 2007 to 2021.
The ghost of ‘transitory’
One difference between the current situation and 2021 is the level of interest rates. Back then, officials needed to raise rates quickly by several percentage points simply to stop providing stimulus to the economy. Today, by contrast, officials believe interest rates are probably at a setting that is high enough to slow down the economy.
Officials in 2021 didn’t fully appreciate how much stimulus was being delivered to the economy from government spending and low rates, said Loretta Mester, who led the Cleveland Fed from 2014 until last year. “We waited a little too long, thinking that the supply side would adjust. And it didn’t,” she said.
This has led some observers to worry the Fed will overcompensate for past mistakes.
The Fed’s latest projections point to the prospect that tariffs will send up prices while sapping investment, sentiment and growth, at least in the short run. – Rebecca Noble/Bloomberg
“Almost by design, they are likely to be late as a penalty for 2021,” said Ed Al-Hussainy, global interest-rate strategist at Columbia Threadneedle. “They’re going to compound the error of the past, where they were inadequately focused on inflation risk, by missing the broader economic deterioration underneath them.”
A strategy along those contours wouldn’t necessarily represent an error, said Mester.
“You’re basically saying, ‘Look, we have a potential inflation problem here. We’re going to be focused on that, and when we get more evidence about what’s happening on the growth side, we’re willing to react at that point—and not before,’” she said. “No one would like to have to do it that way. But it may be that in this environment, that’s what they’re going to have to do.”
Courtesy/Source: WSJ
