The Fed Faces Trump’s Tariffs

A t its December meeting, the Federal Open Market Committee (FOMC) lowered the target range for the policy interest rate by 25 basis points, to 4.25–4.50 percent, as widely expected by the market. As also expected, the FOMC signalled it expected to continue loosening monetary policy in 2025, albeit through two rate cuts rather than the four cuts it had projected in its September forecast. In his press conference after the meeting, Fed chairman Jay Powell emphasized that since September, data on both inflation and the growth of the economy have come in somewhat stronger than expected, indicating that less monetary loosening is needed for inflation to be guided down to the Fed’s 2 percent target. This shift to a less dovish policy outlook does not appear to have been a direct response to President-elect Trump’s recent threats to raise tariff rates, although Powell acknowledged that some of the officials contributing to the forecast may have taken into account future policy actions by the administration.

Much of the reason that Powell wanted to deny that the Fed was preparing to tighten policy in response to Trump’s tariff plans (or his fiscal plans) was political — he does not want to draw Trump’s ire, as the Fed did during Trump’s first administration. Nonetheless, from a purely economic policy standpoint, it is also the right thing to do. Monetary policy affects the economy with “long and variable lags,” often judged to be one to two years ahead. So in principle, if hikes in tariffs are expected in 2025 or 2026, the Fed should be adjusting its monetary policy now in order to head off any inflationary impacts of those tariffs.

The problem, of course, is that it is impossible to know whether Trump will actually boost tariffs, when he will do so, against which trading partners, and by how much. This uncertainty makes it very difficult to use monetary policy preemptively in anticipation of his trade policies. If tariffs are not raised substantially in the next year or two, preemptive monetary tightening would risk depressing the economy for no good reason. The best strategy for the Fed to prepare for large tariff hikes is to analyze their likely effects on the economy and the implications for monetary policy, but hold off on taking action until the size, scope, and timing of those hikes become more apparent.

This is the exact strategy followed by the Fed during Trump’s first administration. By the middle of 2018, a number of tariff hikes had already taken place, but amid a burgeoning trade war with China and multiple threats against other countries, it was impossible to predict where tariff levels would end up. Accordingly, the Fed’s staff decided against incorporating the effects of potential further tariff hikes into their baseline forecast of the U.S. economy. Instead, they devised an alternative scenario in which the United States increases tariffs on all imported goods by 15 percent. The implications for unemployment, inflation, the trade balance, and, ultimately, the appropriate stance of monetary policy were then analyzed and shared with the FOMC. In the event, despite the continued churning of trade negotiations during the remainder of the first Trump administration, tariffs never rose to a level that would have substantially impacted the U.S. economy, and so the FOMC never had to act on those policy prescriptions.

Besides the tremendous uncertainty about how trade policy will evolve during Trump’s second term, there is another reason why the Fed should hold off, for now, on responding to the threat of future tariffs. Even if we knew the size, scope, and timing of those tariffs, it would not be clear how monetary policy should react. On the one hand, higher tariffs would be inflationary, as they not only raise prices of imported goods, but they also allow domestic producers of such goods to raise their prices as well. This would call for tighter monetary policy. But, on the other hand, higher tariffs also depress economic activity by cutting into the spending budgets of U.S. consumers, boosting the cost of inputs for producers, and triggering foreign retaliation against our exports. This would call for looser monetary policy.

The scenario for a 15 percent across-the-board tariff hike constructed by the Fed staff in 2018 clearly highlighted its contradictory impacts. In the scenario, inflation rises from below 2 percent to nearly 3 percent, but the economy subsequently falls into recession. In consequence, interest rates first rise to contain mounting price pressures but then fall in order to restrain the rise in unemployment. The Fed staff emphasized the uncertainty of these predictions, as there was very little recent experience with such large and broad-based trade barriers. In his recent press conference, Powell specifically referred to the Fed staff’s 2018 analysis in underscoring this uncertainty, and he expressed that more analysis (which he implied was ongoing) would be needed to assess the appropriate monetary response.

All told, monetary policy is going to have to be especially data-dependent in 2025 as we gain clarity not only about the size of eventual tariff hikes but also how they are affecting prices and economic activity. The Fed is well-positioned to meet this challenge, as its current policy interest rate of 4.25–4.50 percent is still well above what is generally estimated to be a “neutral” rate of around 3 percent. This means the current policy is still restrictive, and if tariff policy proves to be more aggressive and inflationary than expected, the Fed can simply reduce the pace of future rate cuts or pause the process entirely. But in any event, if Trump’s most extreme tariff threats come to fruition, and if this threatens the stability of prices and the economy, the Fed must react forcefully and without regard for outside political pressures.