The Fed will likely stand pat after flurry of rate cuts. After that? It's anybody's guess.
Paul Davidson, USA TODAY
7 min read
The Federal Reserve almost certainly will hold its key interest rate steady this week after cutting it by a total percentage point at three straight meetings amid easing inflation.
And then?
Roll the dice.
President Donald Trump’s plans to cut taxes, impose hefty tariffs on key imports and deport millions of immigrants who lack permanent legal status have generated unusual uncertainty about the course of the economy, inflation and interest rates.
Under many forecasters’ baseline scenario, his policies could modestly stoke inflation while the economy slows but posts solid growth. That could mean two or possibly three rate decreases this year.
The U.S. Federal Reserve Building in Washington, D.C.
Alternatively, Trump’s initiatives could more emphatically reignite inflation while the economy grows sturdily or possibly heats up. That likely would translate to fewer rate cuts – perhaps none - and may even put rate hikes back in play, forecasters say.
Another possibility: Trump’s blueprint could drive inflation higher while also weakening the economy – an unusual tandem that would pose a vexing dilemma for the Fed. Cut? Hike? Stand pat?
Why does the Fed manipulate interest rates?
The central bank lowers rates to stimulate a soft economy and job market; it raises rates or keeps them higher for longer to tame inflation.
Fed officials aren’t expected to release new forecasts for the economy and interest rates after a two-day meeting concludes Wednesday. And so the public will look for clues in Fed Chair Jerome Powell’s post-meeting news conference. But the range of possible economic outcomes is dizzying, and Deutsche Bank said in a research note that Powell “is unlikely to provide explicit guidance on upcoming policy decisions.”
“There’s a lot of uncertainty,” said Jonathan Millar, senior U.S. economist at Barclays and a former Fed economist. “Lots of crosscurrents.”
Why?
It’s unclear how aggressively Trump will impose tariffs and deport immigrants and what their effects will be on inflation and the economy. And while tariffs and an immigration crackdown could dampen growth, Trump’s tax cuts and deregulation could boost activity.
Why did the Fed decrease interest rates?
After hiking its key rate to a 23-year high of 5.25% to 5.5% to curtail a pandemic-related inflation spike, the Fed has lowered the rate since September as inflation has slowed from a peak of 9.1% in mid-2022 to 2.9% in December – still above the Fed’s 2% goal.
Inflation has remained stubbornly high recently, though a core measure − which excludes food and energy and is more closely watched by the Fed since it reflects more sustainable trends − ticked down in December.
What is the state of the job market?
Meanwhile, the labor market picked up steam last month after slowing previously, with employers adding a booming 256,000 jobs and unemployment dipping to a historically low 4.1% from 4.2%. Last year, the economy likely grew close to a vibrant 3%, estimates show. It's expected to downshift to a still-solid 2.2% pace this year, according to economist surveyed by Wolters Kluwer Blue Chip Economic Indicators.
The slowing inflation pullback, combined with an economy that appears in little urgent need of the Fed’s aid, left central bank officials predicting a more gradual pace of rate cuts this year so they can ensure high inflation has been stamped out.
Trump’s policies are a wild card that could have an even bigger impact on prices, and some Fed officials said they figured his plans into their forecasts.
The president’s tariffs likely would be passed along to consumers through higher prices, experts previously told USA TODAY. And deporting immigrants could shrink the labor supply and force employers to raise wages, likely leading to higher prices.
Here’s a look at various scenarios that could result from Trump's economic policies.
Moderate inflation, solid economy
This is what many top economists predict, and it's in line with Fed forecasts. It assumes tariffs will push up prices and slow but not derail inflation’s broad slowdown as a pandemic-induced surge in worker pay continues to slow.
Goldman Sachs figures the Fed won’t put too much stock in the effects of tariffs on inflation because they reflect a one-time rise in prices that won’t keep pushing inflation higher in coming years.
Also, the decline in imports triggered by the tariffs would strengthen the dollar, making goods from overseas cheaper for Americans and at least partly offsetting the tariff effects, said Joseph LaVorgna, chief economist of the National Economic Council during Trump’s first term who now holds that title at SMBC Nikko Securities. That, he said, should let at least some companies absorb the cost of the fees without hiking prices.
Meanwhile, Goldman Sachs said the strong December jobs report reflects an economy that can withstand fewer rate cuts.
Goldman expects two cuts this year, in line with Fed officials’ estimates.
Modest inflation, growing concerns about economy
Ryan Sweet, chief U.S. economist of Oxford Economics, believes inflation will resume a sharper descent early this year and the effects of the tariffs on prices is uncertain. At the same time, he said, tariffs could hamper the economy.
That’s because consumers hit with higher prices may reduce spending while businesses worried about import duties may pull back investment. And countries whose shipments to the U.S. are socked with tariffs could retaliate with their own levies on U.S. exports, further denting the economy.
Also, while net job growth is still strong, that’s because companies aren’t laying off many workers. Beneath the surface, hiring has fallen below pre-pandemic levels and it’s taking unemployed workers longer to find jobs, Sweet said.
“The Fed has pledged not to fall behind the curve on the labor market,” Sweet said.
Still another worry: A recent rise in long-term interest rates – partly due to inflation fears - that have pushed up consumer and business borrowing costs.
Sweet believes the Fed will be more concerned about managing the risks of a slowing economy than the uncertain inflation hazards posed by tariffs.
He predicts three rate cuts this year, with the first coming in March.
High inflation, solid economy
Millar of Barclays is more confident that both tariffs and the immigration crackdown will lift inflation by the second half of the year.
And though the effect of the duties on prices could be a one-time blip, he said the Fed will be hard-pressed to tell whether the inflation pick-up is caused by the tariffs or labor shortages resulting from deportations.
“The Fed will be getting mixed signals,” he said.
The prospect of tariffs is also starting to push up consumers' inflation expectations, which could affect inflation itself if workers demand larger pay hikes.
Noting that consumer spending and economic growth remain strong, Millar expects just one rate cut this year.
High inflation, hot economy
Deutsche Bank similarly thinks tariffs and immigration constraints will affect the Fed's inflation outlook.
But the research firm also believes Trump’s plan to work with Congress to extend and expand his 2017 tax cuts, along with his deregulation push, could juice business confidence and growth, further raising inflation risks.
Deutsche Bank expects the Fed to hold off on rate cuts this year, titling a recent report, "Growth too fast, inflation too furious for Fed cuts."
In that scenario, even a rate hike is possible, though unlikely, Millar said.
High inflation, weak economy
It’s possible tariffs and deportations would both increase inflation and undermine the economy and job market, a rare combination known as stagflation.
That could leave the Fed in a quandary over whether to cut rates, raise them or sit on its hands.
“That is the Fed’s worst nightmare,” Millar said.
If an inflation surge and weak growth occurred at the same time, Millar said it’s likely the Fed would prioritize the wobbly economy and cut rates. But if high inflation came first, prompting consumers and businesses to reduce spending later, rate hikes could be followed by cuts.
