Donald Trump’s tariff barrage may trigger a response from the Federal Reserve that the new president won’t like.
Trump is promising across-the-board charges on imports when he’s back in the White House. In his first term, Fed staffers gamed out a similar scenario and concluded that inflation would accelerate – but not for long. And since the tariffs were ultimately seen as a drag on the economy, they prescribed lower interest rates as the best remedy.
But there are two big obstacles to taking that kind of approach now. First, the Fed still hasn’t fully vanquished the post-pandemic surge in living costs. And second, it got badly burned by describing that episode as “transitory.” So the last thing Chair Jerome Powell and colleagues will likely want to do is dismiss price spikes on the grounds they’re not expected to last.
The upshot: Any sign of a tariff-led bump in inflation could lead to the higher interest rates that Trump regularly rages against.
Even a price increase seen as temporary could push the Fed into rate hikes or “at the very least keep them on the sidelines and keep them from cutting as much as they’d like to otherwise,” said Justin Weidner, a US economist at Deutsche Bank.
“It’s definitely a very tricky messaging environment for them,” Weidner said. “They would have to acknowledge the actual inflation rates. They could maybe not use ‘transitory’ or ‘temporary,’ but could say ‘elevated due to tariff effects’ or something like that — make it clear that this is a function of tariffs, and not necessarily demand.”
Day-One Tariffs
After hitting a four-decade high in 2022, inflation has come most of the way back down to the Fed’s 2% goal. Still, underlying measures show higher-than-normal prices in many areas.
It’s a very different environment than in the years leading up to the pandemic, when Fed officials worried that inflation was too low. Trump’s first-term tariffs were relatively small and targeted, and they didn’t do much to change the price outlook.
The president-elect is promising broader measures for his second go-around. On the campaign trail, he floated a charge of up to 20% on all imports and 60% on China. Last week, he threatened to slap 25% tariffs on goods shipped from Mexico and Canada – two of the biggest US trading partners – on Day One of the new administration.
Of course, uncertainties swirl around all these numbers, which may turn out to be bargaining chips rather than set-in-stone plans. And even if Trump does end up raising tariffs significantly, he may do it in stages, taking some pressure off the Fed.
Powell says the central bank will respond to the new administration’s policies only when they’re in place, so none of this will likely affect decisions in the immediate future. Fed officials are expected to cut rates at their Dec. 17-18 meeting, and the next one after that is in late January, just days after Trump’s inauguration.
Still, in view of what’s likely in store, the exercise Fed economists ran in September 2018 is enlightening.
‘See-Through’ Appropriate
The study — presented to policymakers in that month’s edition of the Tealbook, a forecasting and strategy document — assumed a 15-percentage-point increase in tariffs on all non-oil imported goods, and a proportionate response from trade partners.
That would depress household and business spending by raising costs and squeezing profits, Fed staffers predicted, and hurt productivity as output shifted to less efficient firms. Finally, they estimated the tariffs would cause core inflation to “surge temporarily” in the first half of 2019.
The economists then laid out two ways policymakers might respond – by tightening policy to counter the higher prices, or opting to “see through” the pickup in inflation and lowering rates a bit to avoid recession.
They concluded that the second course was a better bet. Since more accommodative policy would shore up growth, and tariff-driven inflation would subside soon anyway, “the see-through policy would seem an appropriate response to a tariff hike.”
The Fed economists attached one big caveat to that conclusion, saying it relied on price expectations staying anchored and “the pass through of cost shocks into inflation being relatively short-lived.”
That hurdle would have been easy to clear in September 2018, after inflation had averaged just 1.4% over the previous decade. It looms much larger now after the pandemic shocks.
And there are other policies promised by the incoming administration, outside of trade, to complicate the outlook for the Fed. Trump has touted a wide range of tax cuts, which could boost demand and drive up prices. He’s also threatened mass deportations that risk destabilizing the economy in various ways.
‘Not Where We Were’
Most economists view Trump’s trade and immigration plans as likely to slow the economy. If they’re right, the Fed could find itself in the tough spot of choosing whether to tighten policy to combat higher inflation, or ease it to support growth. In 2018, the year Trump’s signature tax cuts took effect, the central bank lifted rates as inflation edged up, only to lower them again in 2019 to counter a slowdown.
All that while, the Fed was regularly getting bashed by Trump for keeping money too tight – and in that respect there’s no reason to think his second term would be any different. The president-elect wants to use tariffs to bring manufacturing back to the US, a goal that could be undercut if high borrowing costs deter businesses from investing.
This year, the Fed began a rate-cutting cycle in September, after the most aggressive hikes since the early 1980s, but it’s moving cautiously and watching inflation carefully.
Powell, whose term expires in 2026, keeps getting asked how the new administration’s plans will change the outlook — as he may be again later on Wednesday when he speaks at a New York event. The Fed chief has stressed the differences between today’s environment and the one that prevailed during Trump’s last presidency.
“Six years ago and such the inflation was really low and inflation expectations were low,” the Fed chair said last month. “Now we’ve come way back down, but we’re not back where we were. Inflation’s still running above 2%. We’ll take all that into account.”
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