The US Federal Reserve and its chair, Jerome Powell, are rightly choosing not to act on any assumptions about what Donald Trump might do as president. That said, if he follows through on his more extreme campaign promises, they’ll struggle to contain the economic consequences — a problem that equity investors ignore at their peril.
The president-elect has been sharply critical of Powell, whom he appointed in 2018. Yet at the first Fed news conference since the election, Powell emphasized that Trump lacks the legal authority to fire him before the May 2026 end of his term, which he plans to serve out. He wisely avoided speculation about how Trump’s promises of higher tariffs, mass deportations and lower taxes might influence monetary policy. The Fed, he said, analyzes the effects of such measures at the proposal stage, but doesn’t consider them in its policymaking until they become law: “We don’t guess, we don’t speculate, and we don’t assume.”
The Fed’s main economic model reinforces this deliberate approach. First, higher tariffs enter the model only once they’re likely to be in place. Second, the model assumes that the monetary-policy response will be consistent with the Fed’s employment and inflation objectives and that businesses and households will fully anticipate such a response. This rules out systematic policy errors, mitigates the impact of economic shocks and ensures that inflation expectations remain well anchored in the model — lowering the perceived cost of waiting. Thus, what Trump does will take considerable time to influence actual policymaking.
If Trump’s policy initiatives prove modest, the Fed’s delay in responding won’t matter too much. But if he does anything big and abrupt — for example with respect to tariffs or deportations — the central bank’s response will occur too late to mitigate fully the economic impact. All else equal, higher import prices and labor shortages will raise inflation and push up expectations of future inflation. This will increase uncertainty and necessitate more aggressive monetary adjustments.
Trump might also want to influence the Fed, ensuring that it keeps interest rates low during his tenure. On that front, his options are limited. In the short run, there’s no conflict as the Fed will likely keep easing anyway. Beyond that, the president won’t have much room to maneuver until Powell’s term ends.
Consider one idea floated during the campaign: Trump could try to undermine Powell by appointing his preferred successor to the Federal Reserve Board, leading markets to pay more attention to the “shadow” chair. I see three reasons this wouldn’t be worth pursuing. First, it would take time: The president would have to either entice a board member to leave (say, to head the Federal Deposit Insurance Corporation) or wait until the next opening, which won’t come until Adrianna Kugler’s term ends in January 2026. Second, Powell would still direct the board’s staff and set the agenda of the policymaking Federal Open Market Committee, two key elements of the chair’s authority. Third, forward guidance about how the Fed might act in the future — which is what the shadow chair could offer — isn’t very relevant at a time when employment and inflation are both close to the central bank’s objectives. Incoming economic data play the dominant role in determining the Fed’s behavior.
Markets’ response to Trump’s victory has been oddly divergent. The increase in bond yields is directionally appropriate, consistent with expectations that the Fed’s short-term interest-rate target will bottom out around 3.75%, not the 2.9% expected a few months ago. To some extent, this reflects the economy’s sustained strength and rising estimates of what the “neutral” interest rates should be. But it also suggests concern about Trump’s policies stoking inflation.
I find the stock market rally baffling. Yes, lower corporate tax rates, deregulation and higher tariffs could lift profit margins, at least temporarily. But there are ample offsetting negatives, including the effect of tariffs on inflation and of deportations on the supply of labor. Add the 50-basis-point increase in real interest rates since late September and the fact that the Fed will have to take away the punch bowl if the Trump party gets too wild, and equity market valuations seem unduly rich. Investors may live to regret their exuberance.
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