The surge in macro uncertainty related to tariffs, including the possibility of a global trade war, has complicated the Fed’s already difficult task of setting interest rates to accommodate an unknown future. The added complication of factoring in how White House policy will evolve, and how that will influence future inflation and economic activity, is about as challenging as it gets when the main tool is the blunt instrument of adjusting interest rates.
The Fed, starting with today’s policy announcement at 2:00 pm Eastern, is “facing the most difficult challenge a central bank ever faces when the shock is both pushing up prices, in terms of imports, and reducing jobs, in terms of input costs. This is what tariffs do,” wrote former Treasury Sec. Larry Summers on Tuesday.
What to do when the stakes and uncertainty are high? Nothing sounds about right, at least for now. “The costs of being cautious are very, very low,” Fed Chairman Powell said earlier this month. “The economy’s fine, it doesn’t need us to do anything, really.”
Fed funds futures agree, and are pricing in a near certainty that the central bank will leave its 4.25%-to-4.50% target range unchanged today. The confidence for standing pat is moderately lower at an implied 80%-plus probability for the next FOMC meeting on May 7. A key question is whether today’s revised Fed economic projections, and Powell’s press conference, will change the calculus?
The policy-sensitive US 2-year Treasury yield has recently started pricing in higher odds for rate cuts by dropping below the median Fed funds target range–again. Earlier in the year, the 2-year was more or less trading in line with the median Fed funds rate, which suggested the market expected a steady policy. But in recent weeks the crowd revised its guesstimates and has turned dovish on the outlook.
At the core of the Fed’s current dilemma is deciding if the risk of higher inflation dominates the threat of slower economic growth. Inflation was already sticky before tariffs, and the odds have likely increased that pricing pressure will remain firm if not accelerate if a global trade war unfolds.
But trade-war risk is also a factor that could slow the economy. As reported yesterday by CapitalSpectator.com, the US first-quarter median nowcast for GDP growth has fallen recently and is currently at a weak 1.2% — close to a stall-speed pace.
By some accounts, looking beyond the first quarter is ringing alarm bells. Clement Bohr, an economist at UCLA Anderson Forecast, writes that if the tariff plans are fully implemented, a recession is likely:
“As 2025 begins to unfold, there are no signs of an imminent recession. However, the stated aim of the Trump Administration is to dramatically transform the U.S. economy in its first 100 days and that begs the question: if fully or nearly fully enacted, could these initiatives cause enough sectors of the economy to contract at the same time and trigger a recession? The answer appears to be yes, that a downturn could result over the coming year or two, and that we should now be on a Recession Watch.”
The burning question is where the Fed comes down on weighing the expected risks for inflation vs. recession? Doing nothing and waiting for more clarity via incoming data may be prudent today, but this will likely be the last time in the foreseeable future that the central bank can walk a tightrope and try to redirect the market’s attention to some point in the future.