Managing the economic fallout of a global pandemic might one day be remembered as an easy job for the Federal Reserve, especially compared to navigating the current administration’s erratic, improvisational trade policy. The central bank wisely chose to leave short-term interest rates unchanged, citing the need to “wait and see.” The problem is that even perfect foresight on tariffs wouldn’t solve what’s coming next.
The Fed has a dual mandate: maintain low inflation and maximum employment. A fresh wave of tariffs, even if watered down from the White House’s opening salvo, threatens to make that mission fundamentally unachievable.
Keeping the federal funds rate steady at 4.25% to 4.5% was a unanimous and thoroughly expected decision. As Chair Jerome Powell pointed out, inflation has dropped near the Fed’s 2% target, and unemployment is hovering at 4.2%, suggesting an economy close to “full employment.” In other words, monetary policy is — for the moment — about right.
But not for long.
The ongoing uncertainty around trade policy is already a problem in its own right. Businesses, ever allergic to unpredictability, are likely delaying investment and hiring. Consumers, meanwhile, are fretting over rising prices and a slowing economy. Even if the tariffs turn out smaller than feared, the economic damage they inflict could still be disproportionate.
The Fed’s challenge isn’t just estimating the scale of the impact—though that’s hard enough. Worse still, the nature of the problem demands contradictory policy responses. Tariffs will almost certainly push up prices, which calls for raising interest rates. But they’ll also likely suppress output and employment, which normally requires cutting rates. So what’s a central bank to do?
As Powell hinted, the Fed must choose which half of its mandate is under greater threat: price stability or full employment. This is why “stagflation”, that delightful mix of stagnant growth and rising prices, remains the Fed’s nightmare scenario. Should that arise, they may be forced to tighten policy even as the labour market weakens — or ease rates as inflation picks up. Either way, cue the political uproar. And they can expect little help — and even less courtesy — from a White House that doesn’t trust anyone but itself.
For now, markets remain surprisingly composed, betting on three-quarters of a point in rate cuts by year-end. But if both sides of the Fed’s mandate stay under pressure, the sensible move might be to do absolutely nothing—keep rates on hold, even as inflation and unemployment rise—an unappetising prospect.
The easiest escape from this policy quagmire is for the administration to wrap up trade talks, declare victory, shelve the tariff threats, and let the Fed get back to its job.
Possible? Yes, it is unlikely. Definitively.