The Federal Reserve’s Tightrope Walk: Tariffs, Inflation, and Rate Cut Uncertainty
The U.S. stock market, struggling to recover from a sharp decline since mid-February, is anxiously awaiting a potential boost. However, the Federal Reserve is unlikely to provide immediate relief, as it grapples with a complex economic landscape complicated by President Trump’s aggressive trade policies.
As the Fed concludes its two-day meeting, the focus will be on its projections for interest rate cuts in 2025. The central bank is caught between its dual mandates of controlling inflation and promoting economic growth, a situation exacerbated by Trump’s tariffs. These tariffs are expected to simultaneously push up inflation and dampen economic activity, leaving the Fed in a precarious position.
To combat inflation, the Fed typically raises interest rates or maintains them at elevated levels. Conversely, to stimulate a weak economy and job market, it lowers rates. The key question is which priority will guide policymakers this week. Will inflation concerns lead them to reduce their rate cut forecasts, or will signs of a slowing economy prompt them to predict more rate decreases, potentially boosting the stock market and overall growth?
Given these conflicting pressures, many top forecasters anticipate the Fed to take a cautious approach, maintaining its December forecast of two quarter-point rate decreases in 2025. However, with inflation remaining high and consumer inflation expectations rising, some believe the central bank might err on the side of caution and reduce its forecast to just one rate reduction, potentially causing further market volatility.
Barclays, in a note to clients, highlighted the difficult trade-off the Fed faces between addressing rising inflation and a weakening labor market. They believe that elevated inflation and surging longer-run inflation expectations will prevent the Fed from responding aggressively to softening economic and labor conditions. Consequently, Barclays expects the Fed to reduce its forecast to just one rate cut.
Similarly, Deutsche Bank, while still projecting two cuts like Goldman Sachs and JPMorgan Chase, acknowledges the risk of only one.
Last year, the Fed lowered its benchmark short-term rate by a total percentage point to a range of 4.25% to 4.5% at three meetings following a substantial easing of pandemic-related price surges. However, inflation has remained stubbornly persistent in recent months, leading the Fed to hold the rate steady.
While inflation slowed unexpectedly in February based on the consumer price index, some economists believe that another key measure closely watched by the Fed, due later this month, likely moved higher.
Most economists had anticipated further easing of inflation this year, but Trump’s tariffs have been implemented sooner and with greater force than expected. Trump has already imposed a 25% levy on imported steel and aluminum, 20% on all shipments from China, and 25% on some goods from Canada and Mexico. Additional duties scheduled to take effect next month include 25% on the remaining imports from Canada and Mexico; 25% on autos, pharmaceuticals, and computer chips; and sweeping reciprocal tariffs that would match whatever other countries charge the U.S.
Goldman Sachs anticipates that these levies will both drive up inflation by half a percentage point, as retailers and manufacturers pass along their higher costs to consumers, and reduce growth by half a point, as households lose purchasing power – a rare combination known as stagflation. Goldman predicts that in its forecasts, the Fed could raise its 2025 inflation forecast from 2.5% to 2.8% and lower its growth estimate from 2.1% to 1.8%.
During his first term, Trump’s more measured tariffs led the Fed to cut rates in 2019 to cushion the economy against a potential downturn. However, inflation is much higher now, Goldman noted, and inflation expectations, which could affect inflation itself, recently rose the most since 1993 amid Trump’s import fees.
This, along with the uncertainty spawned by Trump’s trade war, should prevent the Fed from projecting additional rate cuts, according to Goldman.
Fed Chair Jerome Powell, noting that the economy "continues to be in a good place," stated early this month that "We do not need to be in a hurry (to cut rates) and are well positioned for greater clarity."
However, there are growing signs of weakness. Retail sales fell sharply in January and increased only modestly last month, signaling potential weakness in consumption, which accounts for 70% of economic activity. Additionally, consumer confidence has declined due to trade conflicts and Trump’s plans for massive federal layoffs.
One factor that could prevent the Fed from predicting more rate cuts Wednesday is that Deutsche Bank and Goldman expect the Fed’s forecast for the unemployment rate by year’s end to remain unchanged at a historically low 4.3%. However, this is primarily due to the Trump administration’s deportations of millions of immigrants who lack permanent legal status, resulting in fewer people competing for jobs.
These deportations, however, will also lead to a weaker economy and slower job growth.
Ultimately, a flagging economy at risk of recession could outweigh the hazards of inflation and prompt the Fed to cut rates more sharply, economists suggest. Barclays anticipates that the Fed will end up lowering rates twice this year and three times in 2026, once more than the research firm previously forecast.
Barclays believes that "the tariff shock will be more significant than the (Fed) will show in its" forecasts.
Goldman also stated that the risks to growth from tariffs are "considerably more serious than they were in 2019."
"If the tariffs we expect are eventually imposed, we think it is quite plausible that at some point this year there might be enough concern about the economic outlook for the Fed to cut even if inflation remains high," Goldman wrote in a research note.
