Things are about to get complicated for the Fed
By The Editors
For the Federal Reserve, the test posed by the global pandemic may soon seem easy compared with handling the current administration’s wildly fluctuating trade policy. The central bank wisely left short-term interest rates unchanged on Wednesday, saying it needs to see what happens next. The trouble is that greater clarity on the outlook for tariffs won’t resolve a rapidly approaching dilemma.
The Fed’s dual mandate is to secure low inflation and maximum employment. New tariffs, even if lower than the White House first threatened, might make it impossible to do both.
The decision to leave the policy rate at 4.25% to 4.5% was unanimous and widely expected. As Chair Jerome Powell explained, inflation has fallen to within sight of the central bank’s 2% target. With a jobless rate of 4.2%, the economy is close to “full employment.” As things stand, monetary policy is therefore about right.
But things are about to get a lot more complicated. For as long as it lasts, the uncertainty surrounding the administration’s tariff plans is a problem in itself. In all likelihood, it’s already causing companies to postpone investments and delay new hiring. It will worsen consumer anxieties about rising prices and a weakening economy. Even if the new trade barriers are lower than expected, it will compound their direct effects.
The problem for the Fed isn’t confined to judging exactly how these pressures will affect prices and employment, difficult as that will be. Worse is that the outlook will dictate contradictory responses. Tariffs will certainly raise prices at the outset; if this initial spike in inflation threatens to become persistent, the appropriate policy will be higher interest rates. But tariffs and related supply-side disturbances will also tend to suppress output and employment, in which case the appropriate policy is lower interest rates.
So what’s the Fed to do?
As Powell has suggested, it will have to assess which part of its dual mandate — stable prices or maximum employment — is more under threat. This is why the Fed sees stagflation as its worst nightmare: It might have to raise interest rates to restrain inflation even though unemployment is climbing, or lower them to avoid a recession even though inflation is going up. Whatever it does, its choices will be a focus of fierce political controversy. And as it tries to do this impossible job, it can expect to be heckled by a White House unwilling to trust its judgment.
Investors, calm for now, continue to think interest rates will be cut by roughly three-quarters of a point later this year. But if the risks to the dual mandate remain equally weighted, it might make sense to leave interest rates unchanged for longer, even as both inflation and unemployment move up. An unnerving prospect. The best way to avoid it is for the administration to wrap up its trade talks as quickly as possible, deem them an unqualified success, roll back its tariff threats and declare the subject closed.
Unlikely? No doubt — but one can hope.
BLOOMBERG OPINION
