Why the Fed faces a dilemma when it comes to interest rate decisions
Paul Davidson, USA TODAY
5 min read
Despite a partial rebound the past two trading days, the U.S. stock market is down sharply from its record high in mid-February and could use a shot in the arm.
With the Fed expected to hold its key interest rate steady at the end of a two-day meeting Wednesday, the drama will center on the number of rate cuts Fed officials forecast for 2025.
Since President Donald Trump’s aggressive tariffs on various imports are projected to push up inflation and dampen economic growth, the central bank is caught uncomfortably between its two mandates.
The Fed raises rates, or keeps them higher for longer, to tame inflation. It cuts rates to bolster a weak economy and job market.
So which of those missions do policymakers serve this week? Should inflation concerns prompt them to scale back their rate cut forecast? Or should signs of a wobbly economy prod them to predict more rate decreases, boosting the stock market and, indirectly, growth prospects?
The U.S. Federal Reserve Building in Washington, D.C.. For RPA. WM/HB
What is the Fed rate prediction?
With forces pulling in both directions, several top forecasters expect Fed officials to play it down the middle and maintain their December forecast of two quarter-point rate decreases in 2025. But with inflation still elevated and consumers’ inflation expectations rising, some say the central bank could err on the side of caution and reduce its forecast to just one rate reduction, potentially generating further market turmoil.
“The (Fed) will face a difficult trade-off between addressing rising inflation and a weakening labor market,” Barclays wrote in a note to clients. “We think the elevated inflation and the surge in… longer-run inflation expectations will prevent the (Fed) from responding aggressively to the softening in economic and labor conditions.”
Barclays figures the Fed will reduce its forecast to just one rate cut. Deutsche Bank, like Goldman Sachs and JPMorgan Chase, is still looking for an estimate of two cuts but sees a risk of just one.
How much did the Fed cut rates in 2024?
Late last year, the Fed lowered its benchmark short-term rate by a total percentage point to a range of 4.25% to 4.5% at three meetings after a pandemic-related price surge eased substantially. But inflation has barely budged in recent months, prompting the Fed to leave the rate unchanged.
While inflation slowed unexpectedly in February based on the consumer price index, some economists believe another key measure the Fed watches more closely, due out later this month, likely moved higher.
Is the US in a trade war?
Most economists had expected inflation to ease further this year but Trump’s tariffs have come sooner and with greater force than anticipated. Trump already has imposed a 25% levy on imported steel and aluminum, 20% on all shipments from China and 25% on some goods from Canada and Mexico.
Duties scheduled to take effect next month include 25% on the remaining imports from Canada and Mexico; 25% on autos, pharmaceuticals and computer chips; and sweeping reciprocal tariffs that would match whatever other countries charge the U.S.
Goldman Sachs expects the levies to drive up inflation by half a percentage point as retailers and manufacturers pass along their higher costs to consumers, and reduce growth by half a point as households lose purchasing power – an unusual tandem known as stagflation. In its forecasts Wednesday, the Fed could raise its 2025 inflation forecast from 2.5% to 2.8% and lower its growth estimate from 2.1% to 1.8%, Goldman predicts.
In his first term, Trump’s more measured tariffs led the Fed to cut rates in 2019 to cushion the economy against a potential downturn. But inflation is much higher now, Goldman noted, and inflation expectations, which could affect inflation itself, recently rose the most since 1993 amid Trump's import fees.
That, along with the uncertainty spawned by Trump’s trade war, should keep the Fed from projecting additional rate cuts, Goldman said.
Noting the economy “continues to be in a good place,” Fed Chair Jerome Powell said early this month, “We do not need to be in a hurry (to cut rates) and are well positioned for greater clarity.
How is the US economy doing right now?
At the same time, there are growing signs of weakness. Retail sales fell sharply in January and increased just modestly last month, boding poorly for consumption, which makes up 70% of economic activity. And consumer confidence has tumbled because of the trade conflicts and Trump’s plans for massive federal layoffs. The Federal Reserve Bank of Atlanta estimates the economy will contract at an annual rate of 1.8% in the current quarter.
One factor that could keep the Fed from predicting more rate cuts Wednesday: Deutsche Bank and Goldman figure the Fed’s forecast for the unemployment rate by year’s end will be unchanged at a historically low 4.3%. Yet that’s chiefly because the Trump administration’s deportations of millions of immigrants who lack permanent legal status will mean fewer people competing for jobs.
Such deportations, though, will also mean a weaker economy and slower job growth.
Ultimately, a flagging economy at risk of toppling into recession could well outweigh the hazards of inflation and prompt the Fed to cut rates more sharply, economists say. Barclays thinks the Fed will end up lowering rates twice this year and three times in 2026, once more than the research firm previously forecast.
“We think the tariff shock will be more significant than the (Fed) will show in its” forecasts, Barclays said.
And Goldman said the risks to growth from tariffs are “considerably more serious than they were in 2019.”
“If the tariffs we expect are eventually imposed, we think it is quite plausible that at some point this year there might be enough concern about the economic outlook for the Fed to cut even if inflation remains high,” Goldman wrote in a research note.
Thist story has been updated with new information.
