Trump Tariffs put Federal Reserve chair Jerome Powell in a pickle

A trade war ties the Fed’s hands by pushing up inflation at the same time that uncertainty is sapping growth.

US Federal Reserve chairman Jerome Powell. Picture: Getty Images

US Federal Reserve chairman Jerome Powell is facing an increasingly dreadful task. Economists, business owners and investors are betting uncertainty created by the rollout of President ­Donald Trump’s tariff hikes will push the economy closer to a ­recession by weakening hiring and spending. That would call for cutting rates to cushion the downturn.

At the same time, the magnitude of tariff increases is likely to lead prices to rise substantially for many imported goods, including materials used by domestic manufacturers. That could make central bankers nervous about inflation and argues for keeping rates where they are despite gathering risks to the economy and labour market.

“They are in a no-win situation,” said Laurence Meyer, a former Fed governor. Congress has charged the Fed with keeping inflation low and stable while maintaining a healthy labour market. It has been at least 40 years since a president’s policies thrust the Fed’s two mandates into such profound potential tension. “This ­administration has generated the worst shock possible for the Fed, and there’s nothing that they can do right now,” said Riccardo ­Trezzi, a former Fed economist who runs Geneva-based Underlying Inflation, a consulting firm.

Mr Powell said last week that the central bank did not “need to be in a hurry” to cut rates, indicating a rate cut isn’t on the table for the Fed’s next policy meeting, which is May 6-7. “You’ll know more … as the months go by. It’s hard to say exactly when you’ll know, but clearly that learning process is ongoing,” he said.

For now, investors are betting the Fed cuts interest rates later this year because the negative hit to growth will so badly weaken companies’ pricing power that inflation will slow after a big initial pop.

But the Fed will be hard-pressed to cut rates to pre-empt that slowdown because if it succeeds in offsetting the weakness, the increase in inflation might last longer. Fed officials have suggested that they could be slower to cut rates than they have in previous episodes until they see the labour market weakening meaningfully.

“If you’re a trapeze artist, you don’t leave the platform until you’re sure your partner is leaving the platform,” said Vincent Reinhart, chief economist at BNY ­Investments. Waiting to see the economy weaken and joblessness rise before cutting rates will be politically hard, particularly because Mr Trump has already called on Mr Powell to cut rates. “It’s very difficult for the Fed to explain to the public” why it has to wait, said Mr Meyer.

Officials pay close attention to what consumers, investors and businesses expect to happen to inflation over the next several years because they believe those expectations can be self-fulfilling. In some ways, the Fed’s problem resembles that of a soccer goalkeeper who must decide whether to dive to the left and focus on inflation or to the right and address weaker growth as an opponent takes a penalty kick. “Maybe they will get lucky, and they choose one of the two sides of the mandate, and it will turn out they did the right thing,” Mr Trezzi said.

Elias Sabo, chief executive of Compass Diversified Holdings, an owner of middle-market businesses, has been telling his portfolio companies to brace for a sharp reduction in sales from the uncertainty caused by tariffs and the price increases he expects to have to pass through to customers.

“We’re instructing CEOs to reduce costs, freeze hiring – and that portends bad things for the economy regardless of the tariff impact,” said Mr Sabo.

While spending by low-income consumers has been squeezed by inflation over the past several years, high-income consumers have continued to spend generously owing in part to the wealth effects of lofty stock prices. A sustained downturn could lead them to sit tight.

Adding to the concern is a sense of bewilderment over the administration’s trade goals – whether the objective is to negotiate deals that end up removing tariffs, which could reduce the incentive to bring production back to the US, or to keep higher tariffs in place to reshore domestic production.

Meanwhile, if some of the tariffs stick and succeed in bringing production back to the US, inflation could be more persistent.

The pandemic showed that even one-time increases in goods prices can last much longer than anticipated. One lesson: It can take longer for prices of services to ­adjust higher following a shock to goods prices, Mr Reinhart said. A big run-up in car prices in 2021 and 2022, for example, helped lead to subsequent increases in car ­insurance prices.

Also, companies are likely to spread the cost of price increases for items subject to tariffs across the broader range of goods or services that they sell, further complicating Fed officials’ decisions.

“Of course they do see the recession risks, but inflation risk at this point is non-negligible for them. It’s really, really big, honestly,” Mr Trezzi said.