Powell Speak: How tariffs will influence Fed monetary policy

17 Apr 2025 , 10:46 AM

TARIFFS ADD A NEW DIMENSION TO FED POLICY

The recent minutes of the Federal Open Markets Committee (FOMC) published by the Fed underlined the risk of stagflation. It refers to a situation when growth slows, unemployment rises and inflation also goes up. It is not an economically comfortable situation to have; but tariffs could potentially create stagflation. That is why, it is necessary for the markets to look beyond the Fed statement and the minutes for clues into the trajectory of interest rates.

In this context, Jerome Powell’s spoke at the Economic Club of Chicago; where he dwelt at length on the outlook for the US economy and the likely trajectory of monetary policy. Powell underlined in his speech that the US economy and markets were currently in a state of flux. While tariff implementation was put on hold for 90 days, China continues to be subjected to tariffs. A lot will depend on how the tariff situation evolves in coming months.

RECENT DATA FLOWS ON THE US ECONOMY

Powell starts with a cautionary statement that the current data may not be fully reflective of the evolving economic situation. The reciprocal tariffs were like an X-factor and the actual impact was quite tough to decipher. However, Powell underlined that the Fed would continue to focus on its dual mandate of price stability and full employment. Here is what Powell said about the current economic scenario in his speech.

• A critical data point will be the Q1-2025 GDP, wherein the final estimates would be published towards the end of March 2025. High frequency data points have suggested that growth had visibly slowed in Q1, compared to the year ago period.
• The major concern was that overall consumer spending had only grown modestly. More importantly, strong imports during Q1-2025, reflected attempts by businesses to get ahead of potential tariffs. That is also likely to weigh on GDP growth.
• The recent survey of households and businesses reported a sharp decline in sentiments amidst uncertain outlook. This largely reflects trade policy concerns. Most forecasts are also expecting the GDP growth to be weak in the first three quarters of 2025.
• Despite lower non-farm payroll growth of just 1.50 lakh jobs a month, unemployment level had remained low due to low layoffs and lower labour force growth. Wage growth was outpacing inflation, so there were no real labour market concerns.
• While inflation had eased from its 2022 peak, it had gradually diverged from the 2% target. At 2.3% expected PCE inflation in March 2025, the concerns were about the likely impact of tariffs on inflation. Core inflation at 2.6% remains a concern.
• What could make a difference to economic data is key policy changes that the Trump government may attempt on trade, immigration, fiscal policy, and regulation. Those policies are evolving, and their effects remain uncertain. However, estimates of near-term inflation have decisively gone up.

So, what does this imply for monetary policy trajectory of the US Federal Reserve.

KEY ASSUMPTIONS FOR UPCOMING MONETARY POLICIES

As Powell rightly pointed out, the tariffs are almost certain to generate a temporary rise in inflation. A lot would depend on how much of the tariff-related price hikes get absorbed by the US corporations and how much get passed on to end users. A key consideration would be; whether it is possible for the Fed to keep longer term inflation expectations anchored. The focus of monetary policy in the coming months would be ensuring that the longer-term inflation expectations stay anchored. It also needs to ensure that a one-time increase in price levels does not translate into persistent inflation.

According to Powell, the one thing that the Fed will increasingly need to do is balance maximum employment and price-stability mandates. After all, without price stability, it is not possible to achieve long periods of strong labour market conditions. It was very likely that the Fed could face a policy dilemma. For example, a stagflation scenario creates a monetary policy challenge. High inflation cannot be addressed by rate hikes as it would deepen the GDP and job cuts. Similarly, rate cuts may be an answer to jobs and GDP, but it could spike inflation to lofty levels.

The good thing is that, for now, the Fed can afford to wait. There is a 90 day pause on tariffs ex-China and the US economy is in relatively fine fettle. If tariffs go through, then the dual mandate of the Fed would be put to a severe test.