This piece originally appeared in the Financial Times on 12 February 2025.
How the U.S. Federal Reserve is – and should be – thinking about tariffs and monetary policy is a topic on many minds these days, from market participants to political pundits.
I served on the Fed as vice chair in 2018–2019 when tariffs, trade wars, and trade policy uncertainty were also in the news during Donald Trump’s first presidential term. As transcripts of meetings of the policy-setting Federal Open Market Committee held during these years show, such factors were analyzed in staff briefings presented at Fed meetings at that time.
Fed Chair Jerome Powell has recently indicated in public comments that the central bank staff’s analysis of tariffs and trade policy uncertainty in 2018–2019 remains a good place to start in 2025.
Back then, inflation was running at or below the Fed’s 2% target, with expectations well-anchored after a decade of below-target increases in prices. As such, the Fed staff analysis concluded that the central bank should be willing to “look through” a one-time price level increase as tariffs drive up prices of imports.
But Powell has also emphasized recently – and correctly, I believe – that initial conditions for inflation and inflation expectations in 2025 are different from the earlier episode.
Inflation, of course, surged well above the 2% target in 2021 and remains somewhat elevated today, running at about 2.5% over the past year. Perhaps even more important, while measures of inflation expectations appear today to remain well-anchored, Fed officials have indicated that they will certainly not take these for granted given the overshoot of 2021–2024.
But the 2018–2019 analysis also highlights that trade policy uncertainty, not just trade policy itself, did have macroeconomic consequences at the time, delivering a headwind to growth.
Indeed, in 2019 the ISM Index of Manufacturing Activity fell from 55 to 48 and the core personal consumption expenditures (PCE) price index – the Fed’s preferred measure of inflation – dropped from 2% to 1.5%, below the 2% target.
The Fed responded to this slowdown in activity and decline in inflation by easing monetary policy with 0.75 percentage points of cuts between July and November of that year.
Given today’s uncertainty about future trade policy and with inflation still running somewhat above target, there has been commentary that officials “are not in a hurry” to cut rates until they see tangible evidence that disinflation has resumed and they are confident it is on a path back to 2%. This makes good sense.
I do believe, however, that markets may be underestimating the likelihood of a scenario in which inflation does not remain stuck this year, but instead begins to move convincingly down toward 2%.
This would probably be due to more limited pass-through of a smaller increase in realized tariffs than many now expect. This might happen in conjunction with growth headwinds arising from elevated uncertainty about not only the details of trade policy but also the ambitious tax, spending, and deregulatory agenda of the Trump administration.
In such an eventuality, financial markets will probably begin to price in more rate cuts based on the Fed’s historic approach to policy. Whether the central bank would deliver those cuts in the scenario I describe would, I believe, hinge on whether it judges that inflation expectations remain well-anchored.
To be sure, heightened policy uncertainty may not in the end represent much of a headwind to the growth outlook or to financial conditions. Witness the U-turn in stock prices on 3 February, when 25% tariffs on Canada and Mexico were delayed 30 days.
On one hand, such uncertainty could delay decisions regarding hiring and investment; on the other hand, recent activity data suggest that some consumption, trade, and inventory accumulation may have been front-loaded in anticipation of tariffs.
It is important to note that foreign-manufactured content constitutes only a portion of products, with substantial domestic added value coming through sales, marketing, logistics, and intellectual property.
The combination of deregulation and policies related to trade and immigration – which influence both supply and demand – may further complicate the monetary policy landscape.
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