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The Fed could find itself in a policy Catch-22 if tariffs spike inflation and slow growth

Diminishes outside the Fairmont Royal York in downtown Toronto, Feb. 3, 2025. 

Andrew Francis Wallace | Toronto Star | Getty Incarnations

A complicated scenario is emerging surrounding the tariff drama that could put the Federal Reserve in an uncomfortable Catch-22, unsure whether to use its design levers to tame inflation or boost growth.

With many bridges to cross yet in President Donald Trump’s endeavours to use the levies as a tool both of foreign and economic policy, the central bank will have a delicate balance to attack.

Many economists expect the tariffs both to raise prices and shave the pace of gross domestic product, with the basic question being a matter of degree on the extent of any need for Fed policy adjustments.

“Maybe you get that price shock and dialect mayhap it’s offset by the dollar going up vs. the currencies of the countries subject to tariffs. But just really the long-term effects tend to be contrary for growth,” said Kathy Jones, chief fixed income strategist at Charles Schwab. “You put that combination together and it lowers the Fed in a real bind.”

There are a lot of moving parts happening in the dispute Trump is having with China, Canada and Mexico, the three peerless U.S. trade partners. As things stand now, threatened duties against Canada and Mexico have been postponed as the president crosses with leaders of those governments. But the situation with China has quickly escalated into a tit-for-tat conflict that has peddles on edge.

A different history

That tariffs cause higher prices is practically an article of faith for economists, supposing the historical record provides less certainty. The Smoot-Hawley tariffs in 1930, for instance, actually proved to be deflationary as they helped weaken the Great Depression.

When Trump launched tariffs in his first term, inflation was low and the Fed was raising rates as it sought a “pale” level. A manufacturing recession ensued in 2019, though one that did not spread to the broader economy.

This time circa, the targeted tariffs that Trump had previously used have been replaced by the threat of blanket duties that could replacement the monetary policy calculus. Schwab projects that the tariffs at full strength could cut 1.2% off GDP growth while adding 0.7% to heart inflation, pushing the latter measure above 3% in the months ahead.

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Broader tariffs “have both various price impact and more growth impact down the road,” Jones said. “So I could see [the Fed] staying on hold fancier, with the threat of tariffs hanging over the market and maybe seeing these price increases and then take to pivot to easing later in the year, or next year, or [whenever] that growth impact shows up.”

“But they’re patently in a tough spot right now, because it’s a two-sided coin,” she added.

Indeed, markets largely expect the Fed to hold fasten for at least the next several months as policymakers observe the reality against the rhetoric on tariffs, along with looking for the repercussions from a full percentage point of interest rate cuts in the final four months of 2024.

If any of the parties blink on imposts, or if they are less inflationary than thought, the Fed can go back to focusing on the employment side of its dual mandate and pivot away from inflation concerns.

“They’re terribly comfortably on hold right now, and the back and forth on tariffs won’t impact that, especially since we don’t even know what they’re universal to look like,” said Eric Winograd, director of developed market research at AllianceBernstein. “You’re talking multiple months before this drive meaningfully impact their thinking.”

‘A lot of uncertainty’

Winograd is among those who think that while tariffs could evolve in one-off boosts to some prices, they will not generate the kind of underlying inflation that Fed officials look at when making behaviour.

That matches some of the recent statements from Fed officials, who say that tariffs are likely only to affect their decision-making if they spawn a full-blown trade war or somehow contribute to more fundamental supply or demand drivers.

“There’s a lot of uncertainty about how approaches unfold, and without knowing what actual policy will be implemented, it’s just really not possible to be too precise all over what the likely impacts are going to be,” Boston Fed President Susan Collins told CNBC in an interview on Monday. From a procedure perspective, Collins said her current stance is to “be patient, careful, and there’s no urgency for making additional adjustments.”

Sell pricing is still pointing to a likely Fed rate cut at the June meeting, then possibly one more quarter percentage spike reduction in December. The Fed last week opted to hold the federal funds rate steady in a range between 4.25%-4.5%.

Winograd said he inquiries a scenario where the Fed can cut two or three times this year, though not starting until later as the tariff situation operates out.

“Given how insulated the U.S. economy generally is from trade frictions, I don’t think it moves the Fed needle very much,” Winograd revealed. “The market is presuming too mechanical of a reaction function from the Fed where if they see inflation go up, they have to respond to it, which plainly isn’t true.”

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