The Federal Reserve Grapples with Trump’s Trade War: A Delicate Balancing Act
The Federal Reserve finds itself navigating increasingly turbulent economic waters, carefully calibrating its monetary policy amidst the rising tide of President Donald Trump’s trade war. In its latest meeting, the central bank held interest rates steady, maintaining its projection for two rate cuts in 2025. This decision reflects a cautious approach, acknowledging the twin threats of escalating inflation and a slowing economy, both fueled by the administration’s aggressive trade policies.
Trump’s recent imposition of tariffs on a wide array of imports and his unveiled plans for even more stringent duties in the coming weeks have injected a significant dose of uncertainty into the economic landscape. The Fed’s decision to adopt a wait-and-see stance underscores its desire to thoroughly assess the scope, duration, and overall impact of these tariffs before making any drastic policy adjustments.
Adding to the complexity, the Fed has revised its economic forecasts, increasing its inflation outlook for 2025 while simultaneously downgrading its projection for economic growth. This acknowledgment of heightened uncertainty is further emphasized by the removal of the central bank’s previous statement that "risks to achieving its employment and inflation goals are roughly in balance."
As a result, the Fed’s benchmark short-term interest rate remains unchanged in a range of 4.25% to 4.5% for the second consecutive meeting. This follows a period of easing, during which officials reduced the rate by a full percentage point from September to December, responding to a significant decline in price increases.
The current rate environment means that consumers will continue to benefit from relatively lower borrowing costs for credit cards, mortgages, and auto loans compared to the previous year. However, they will also experience lower yields on bank savings accounts. Moreover, the pause in rate cuts suggests that further decreases are unlikely in the immediate future.
The Fed’s decision to hold steady on rates this year is largely driven by persistent inflation. While initially expected to be a brief pause, Trump’s tariffs have introduced a new dynamic, arriving sooner and on a larger scale than anticipated. This necessitates a reassessment of the Fed’s interest rate outlook.
Adding to the complexity are concerns surrounding the President’s federal layoffs and the deportation of millions of undocumented immigrants. These actions further cloud the economic outlook and contribute to overall uncertainty.
The trade battles, in particular, pose a unique challenge to the Fed. Typically, the central bank lowers interest rates to stimulate a weakening economy by making loans more affordable. Conversely, it raises rates, or keeps them elevated, to combat inflation by increasing borrowing costs and cooling down economic activity.
However, tariffs have the potential to both increase inflation, as manufacturers and retailers pass on the added costs to consumers, and dampen economic growth by reducing consumer purchasing power. This creates a difficult situation for the Fed, forcing it to navigate between its dual mandates of maintaining price stability and promoting full employment. The possibility of stagflation, a rare combination of high inflation and slow economic growth, looms large.
For the time being, the Fed appears to be reserving judgment on which risk poses the greater threat, leaving its December rate forecast for 2025 unchanged. Fed officials anticipate lowering the federal funds rate by half a percentage point this year, bringing it to a range of 3.75% to 4%, according to their median estimate. However, a growing divide exists among policymakers, with differing views on the appropriate course of action. Some favor two rate cuts, while others prefer three, and some believe that one or even no cuts are necessary.
Looking further ahead, officials project another two rate cuts in 2026, bringing the rate to approximately 3.4%, consistent with their previous forecast.
Inflation expectations have been revised upward, with officials now projecting their preferred measure of annual inflation to rise from 2.5% to 2.7% by the end of the year, exceeding the 2.5% predicted in December. Similarly, the core inflation reading, which excludes volatile food and energy prices, is expected to increase from 2.6% to 2.8%, surpassing the previous estimate of 2.5%.
Economic growth expectations have been lowered, with the Fed now anticipating the economy to expand by 1.7% this year, down from its prior estimate of 2.1%. The unemployment rate is projected to rise from the current 4.1% to 4.4% by year-end, higher than the December forecast of 4.3%.
The impact of Trump’s trade policies is already being felt. He has imposed a 25% tariff on imported steel and aluminum, a 20% tariff on all shipments from China, and a 25% tariff on certain goods from Canada and Mexico. Additional levies are scheduled to take effect next month, including tariffs on the remaining imports from Canada and Mexico, automobiles, pharmaceuticals, computer chips, and sweeping reciprocal tariffs that would match whatever other countries charge the U.S.
Goldman Sachs estimates that these tariffs will drive up inflation by half a percentage point and reduce economic growth by a similar amount. Other economists anticipate an even greater impact, potentially reducing both inflation and growth by as much as a full percentage point. JPMorgan Chase has increased its recession odds to 40%.
The Fed’s preferred measure of overall inflation declined sharply last year following a pandemic-related surge, but has since plateaued at 2.5%, above the central bank’s 2% target. The core reading fell to 2.6% in January but is believed to have rebounded to 2.8% in February, remaining relatively unchanged in recent months.
Meanwhile, the economy has shown signs of weakening. Retail sales fell sharply in January and only rebounded modestly last month, raising concerns about consumer spending, which accounts for 70% of economic activity. Consumer confidence has declined due to the trade conflicts and Trump’s federal layoff plans.
The S&P 500 index has fallen by about 8% from its record high in mid-February, eroding wealth for higher-income Americans who have been driving spending gains. While U.S. employers added a respectable 151,000 jobs last month, underemployment has risen to its highest level in over three years as businesses have reduced employee hours.
The Federal Reserve Bank of Atlanta estimates that the economy will contract at an annual rate of 1.8% in the current quarter.
While Goldman Sachs and Barclays believe that the Fed will initially maintain high interest rates, they acknowledge that the economic risks posed by large tariffs could eventually force officials to cut rates more aggressively than currently anticipated.
In addition to its interest rate decisions, the Fed also made a technical adjustment to its financial portfolio. It has been gradually reducing its holdings of Treasury bonds and mortgage-backed securities, reversing the stimulus provided during the pandemic and exerting slight upward pressure on long-term interest rates.
However, excessively rapid balance sheet reduction could disrupt financial markets, especially during a period of debate in Congress and the White House over raising the debt ceiling. This process could also affect the Treasury Department’s holdings at the Fed as the government strives to preserve cash.
Therefore, the Fed agreed to reduce the monthly runoff of its Treasury bonds from $25 billion to $5 billion. This move aims to strike a balance between tightening monetary policy and avoiding undue disruption in the financial markets. The Federal Reserve’s current position reflects the challenging task of steering the economy through a period of heightened uncertainty, balancing the risks of inflation and recession while navigating the complexities of the trade war.
