Just after President Trump clinched victory in the 2024 election, Jerome H. Powell, the head of the Federal Reserve, skillfully dodged a query regarding the central bank’s strategy for dealing with a challenging mix of high inflation, stagnant growth, and rising unemployment. When asked, Powell reassuringly responded, “The aim is to avoid stagflation,” adding with a hopeful note, “Knock on wood, we’ve managed to get this far without significant weakening in the labor market.”
Fast forward two months, and the aggressive tariff moves and sharp cuts to federal operations announced by Trump have tossed the Fed into a precarious situation. While outright stagflation seems a distant possibility, given the robust base of the U.S. economy, the perceived seamless soft landing where the Fed tames rapid inflation while maintaining economic stability now seems increasingly uncertain.
As the Fed concludes its policy meeting this Wednesday, it’s widely anticipated that interest rates will remain between 4.25% and 4.5%. Powell has recently minimized the need for immediate changes, emphasizing that the central bank is focused on “separating the signal from the noise” amidst Trump’s policy initiatives. With the current favorable economic conditions, Powell mentioned that the Fed is “well positioned to wait for more clarity.”
However, should the economy begin to deteriorate and inflationary pressures mount—a scenario that consumers are growing anxious about—navigating policy decisions will become significantly more challenging for the Fed, potentially thrusting it directly into Trump’s sights.
Mahmood Pradhan, who leads global macro at Amundi Investment Institute, observed, “The Fed is certainly in a bind. It’s grappling with factors outside its control—uncertain policies and volatile discussions about tariffs. That’s a tough hand they’ve been dealt.”
Fed officials have gotten quite adept at skirting around questions concerning Trump’s policies. Yet, the whirlwind of actions from the administration in the initial months of Trump’s second term has made dodging such topics increasingly challenging. The avalanche of tariff threats alone has broadened the spectrum of potential economic impacts, leaving even the most optimistic economists wary. They also have to consider Elon Musk’s drastic government spending cuts and the looming threat of deportation for millions of immigrants.
Trump’s hesitation to rule out the possibility of a recession and his advisors’ recent shift in tone regarding the potential sacrifices needed for economic expansion have fueled concerns about the extent of the administration’s commitment to its agenda. Last week, Trump’s dismissive stance towards warning signs shook the financial markets further.
There’s emerging evidence that the tariff-related uncertainty is already making an impact. For instance, the University of Michigan’s preliminary survey noted a third consecutive decline in consumer sentiment this March.
Discussions around tariffs have surged during corporate earnings calls, as highlighted by FactSet. CEOs are increasingly flagging concerns about dwindling demand and rising prices. Meanwhile, optimism about the job market is waning, with more consumers expecting higher unemployment rates and tougher financial conditions in the coming year, according to the Federal Reserve Bank of New York.
“Consumption has been a major driving force for the U.S. economy over the last few years, but it may not continue to contribute as strongly moving forward,” remarked Marc Giannoni, chief U.S. economist at Barclays, who previously worked with the Fed in its Dallas and New York branches.
Recently, Giannoni’s team updated its U.S. growth forecast, trimming it by nearly a full percentage point to 0.7% on a fourth-quarter-over-fourth-quarter basis. JPMorgan and Goldman Sachs have followed suit with similar revisions, attributing them to tariffs and the anticipated investment slowdowns due to trade policy uncertainties.
A concerning trend is the simultaneous upward revision of inflation forecasts. Companies expect costs to rise due to Trump’s tariffs, which are likely to increase prices on imported goods. Many foresee passing these costs on to consumers.
Tom Madrecki from the Consumer Brands Association noted that prominent food companies such as PepsiCo, General Mills, and Conagra Brands might suffer if tariffs are imposed on products not readily sourced domestically. “There’s no winning here,” Madrecki commented. “There’s no avoiding grocery price hikes, yet consumers are already at their breaking point.”
Madrecki’s group recently petitioned Trump for tariff exemptions for items like coffee, cocoa, and oats mainly sourced from abroad. He pointed out that such exemptions could help companies avoid absorbing additional costs, which wouldn’t contribute to job creation or investment in new facilities.
Inflation expectations among Americans are on the rise, both in the short term and over five years. While some economists downplay the significance of these indicators, citing the partisan slant in survey responses, the diversity of views on inflation paths is a worry for others.
“There’s a lot of disagreement about inflation trajectories, which suggests that inflation expectations are not anchored,” noted Yuriy Gorodnichenko, an economist at UC Berkeley. He added, “People’s beliefs about inflation can easily shift because everyone is so uncertain and confused.”
The evolution of these inflation expectations will be crucial in guiding the Fed’s policy direction. Historically, the Fed has maintained that it can overlook temporary inflation spikes caused by tariffs. For instance, during the trade tensions of Trump’s first term, the Fed lowered interest rates in 2019 amidst growth concerns.
However, with inflation still stubbornly above the 2% target, the Fed’s options may be more constrained if the economy weakens. Powell suggested that the Fed’s stance on tariffs would depend on “what’s happening with longer-term inflation expectations and the persistence of tariff-induced inflation,” indicating a continued focus on price stability.
Complicating matters is Trump’s tendency to challenge the Fed’s political autonomy. Although he has refrained from frequent commentary about Powell and monetary policy decisions this term, Trump has leaned towards executive orders to exert influence over the Fed.
Jon Faust, who served as a senior advisor to Powell until recently, stated, “The absolute no-go is allowing inflation and inflation expectations to rise together, as that’s the worst-case scenario that cannot be permitted.” Faust, now at Johns Hopkins University, reflected on Trump’s approach, “It seems President Trump is less constrained by conventions this time. The economic landscape could easily become more strained with a slowing economy and potential tariff-induced inflation spikes. This sets the stage for a probable confrontation between the Fed and the administration.”
