Macro Signposts | 6 May 2025
Tariff Tensions and the Fed's Policy Puzzle
The Federal Open Market Committee (FOMC) faces something of a predicament on Wednesday. This will be the Federal Reserve's first meeting since the Trump administration's 2 April tariff announcement - a move that, after some subsequent back-and-forth and a 90-day reprieve on reciprocal measures, has left the U.S. average effective tariff rate for most countries around 10% (and slightly higher for those exporting a lot of autos to the U.S.), while China faces punishing 145% tariffs. The net result: a 10-15 percentage point jump in the average effective tariff rate this year, marking the most significant trade policy shift in a century. Yet, despite what could be a meaningful shock to the U.S. and global economies, expectations for this FOMC meeting are muted.
Initial conditions of a relatively solid economy and above-target inflation, plus the economic implications of tariffs, put the central bank in a tricky spot. With tariffs, the near-term impacts tend to be higher inflation but lower real economic activity, including employment. Thus, the central bank must balance the risks and potential benefits of policy decisions: It can lower rates to support growth and employment (risking higher inflation), or raise rates to restrain inflation and keep inflation expectations anchored (risking higher unemployment). The central bank's best strategy out of several bad options may be to simply wait for more clarity.
In order to cut rates, we think the Fed will need to be confident that inflation expectations are well-anchored and recession risks are rising. This assurance may not come until the data show definitive evidence that the labor market is decelerating or contracting - evidence that hasn't yet emerged in the data.
Looking ahead, given the high degree of uncertainty surrounding trade policy and economic adjustments (and data release lags), we believe the Fed may not have clear evidence of labor market deterioration until later this summer or fall (i.e., the September meeting). However, once it's clear that the U.S. labor market is weakening, the Fed is likely to cut 150-200 basis points (bps) relatively quickly, assuming the downturn is mild.
That is our baseline Fed outlook. Below, we address other frequently asked questions about the Fed and the U.S. economy.
Shouldn't the Fed look through the price level adjustment?
Tariffs, after all, are essentially a tax that also delivers a one-off increase in the price of foreign goods relative to those made in the U.S. In textbook terms, this is a classic supply shock. More expensive imports push up the overall price level, squeeze real disposable incomes and corporate profits, and, in turn, tend to hinder consumption, investment, and employment. Weaker demand and investment should exert downward pressure on inflation.
Yet, while supply shocks are meant to produce only a fleeting burst of inflation, Fed officials are acutely aware of the risks that come with both the scale and timing of this episode. Core inflation could well breach 4%, and the memory of the pandemic's inflationary surge is still fresh. The danger is that such shocks could increase inflation expectations and stoke nominal wage growth, making it harder for the Fed to bring inflation back to target without a firmer hand on policy.
History offers a cautionary tale. The 1970s and 1980s were marked by a succession of supply shocks, most notably the OPEC oil embargo of 1973, which sent oil prices soaring and production costs spiraling. A second oil shock in 1979 only compounded the pain. Inflation expectations ratcheted higher, helping to entrench inflation long after the initial shocks had faded.
Worryingly, inflation expectations are once again on the rise. Surveys show that households, businesses, and forecasters alike are bracing for higher inflation, with one-year-ahead expectations now back at pandemic-era highs - well before any broad-based evidence of firms raising prices. Longer-term measures, such as the University of Michigan's five-year, five-year-ahead gauge, have climbed to levels unseen in a quarter-century. The coming release of the Philadelphia Fed's professional forecaster survey - which includes a question on the long-term inflation forecast - will be closely watched for further signs of shifting sentiment.
With the lessons of the stop-start monetary policy era still in mind, Fed officials are likely to proceed with caution, waiting for clear evidence that inflation expectations remain firmly anchored before making their next move.
How have central banks responded to tariffs in the past?
Building off recent research from the World Bank1 offers some clues. A study of 16 advanced economies from 1960 to 2019 finds that, on average, central banks raised policy rates by 13 bps for every percentage point increase in effective tariff rates. The response, however, was not symmetric across economic environments. In periods when inflation was running hot - specifically, when the three-year average exceeded 4% - central banks were far more hawkish, lifting short-term rates by as much as 40 bps for each percentage point rise in tariffs. In cooler, low-inflation environments, policy rates barely budged. Notably, in neither scenario was the instinct to cut rates the prevailing response.
Today, the data indicate the U.S. is likely in the former camp: As of March, the three-year average for headline inflation stands at 4.6%. While markets and policymakers alike see little chance of a return to rate hikes, the risk remains that another sharp price-level adjustment could entrench inflation expectations and prolong inflation's stint above target. That, in turn, may keep the Fed's hand steady - at least until the labor market shows unmistakable signs of strain.
What is the outlook for the U.S. labor market?
Pinpointing when it might start to contract is a key question. Trade policy, shifting immigration rules, Federal government layoffs, and a general air of uncertainty are all expected to weigh on the labor market at different points this year. For now, we believe the risk is that any real deterioration will not show up until summer - which means hard evidence of a slowdown may not be in hand until the Fed's late July or - more likely - mid-September meeting.
Various crosscurrents inform the employment outlook:
Bottom line
Even if trade tensions de-escalate and tariffs moderate, the U.S. is still facing import duties much higher than anything seen in recent history. We estimate that the average effective tariff rate on U.S. imports will settle in a range from 10%-15%. The near-term consequences are clear: higher inflation, lower real incomes, and contracting investment. The longer-term effects are less clear, but could include greater investment in U.S. industries - time will tell.
For now, the economic implications put the Fed in a tough spot. Tariffs should induce a one-time price level adjustment, but the lessons of the 1970s and 1980s loom large: The Fed likely wants to ensure inflation expectations remain well-anchored.
Fed officials likely need hard evidence of labor market weakness before cutting rates. Given the lags in production lead times and price increases, which affect real volumes, the Fed may not get the data until later this summer or early fall. Nevertheless, once it comes, we expect the Fed to cut fairly quickly.
1 Davide Furceri, Swarnali A. Hannan, Jonathan D. Ostry, Andrew K. Rose, "The Macroeconomy After Tariffs," The World Bank Economic Review, Volume 36, Issue 2, May 2022, pages 361-381.
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