(Bloomberg) -- President Donald Trump’s rapidly evolving trade war threatens to resurrect an all-too-familiar question for the Federal Reserve: If inflation moves higher, will it be transitory?
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Trump’s decision to slap tariffs on America’s largest trading partners — and his vows for more levies — could dampen economic growth and add to already stubborn inflation. But policymakers have made clear the central bank’s reaction will depend on whether they believe the tariffs are stoking a one-time price increase or causing longer-lasting ripple effects.
“It’s the dreaded T word,” said Michael Gapen, chief US economist for Morgan Stanley. “It’s the word that shall not be named.”
The situation now could conjure bitter memories over how the central bank failed to respond quickly enough to inflation triggered by the pandemic. As prices soared, Chair Jerome Powell — and many economists outside the Fed — insisted they need not raise interest rates because inflation would prove “transitory.”
While policymakers mounted an aggressive response to wrestle inflation down from a four-decade high, the delay damaged the Fed’s credibility. Inflation still hasn’t returned to target and yet officials may face the same the tough choice again.
Treasury Secretary Scott Bessent on Thursday made clear what side he’s on.
“Tariffs will be a one-time price adjustment,” Bessent said at the Economic Club of New York. “While I’ve agreed not to talk about prospective Fed policy going forward, I would hope that the failed team transitory could get back together and think that nothing is more transitory than tariffs.”
It’s not the Fed’s first time confronting Trump’s tariffs. Policymakers ultimately lowered rates during the president’s first term to head off slower growth. But unlike then — when inflation was near target and had been for roughly a decade — price pressures are top of mind for both the Fed and the American public.
“Number one priority is to ensure that inflation does not accelerate, does not get entrenched,” said Mark Zandi, chief economist for Moody’s Analytics. “And if they feel confident they’ve accomplished that, then they turn to growth.”
After lowering interest rates by a full percentage point at the end of last year, Fed officials have signaled they’re likely to keep rates steady for the foreseeable future as they await confirmation inflation is sustainably falling and further clarity on the impact of Trump’s policies on the economy.
Worries about the economic growth outlook, however, have risen in recent weeks. Investors are now betting the central bank will lower borrowing costs three times this year, according to futures markets. Policymakers will have to weigh the risk that tariffs could slow growth against concerns the levies will lead to higher prices.
Tariff Ambiguity
But Fed officials have some time to figure it out. There is uncertainty over the details, duration and scope of Trump’s final trade policies, and the levies are subject to constant flux — as evidenced by the White House’s decision Thursday to exempt Mexico for now from the new 25% tariffs on any goods and services that fall under the North American trade agreement known as USMCA.
“There’s a lot of uncertainty. We don’t know how long the tariffs will apply. We don’t know what other countries may do in response to this,” New York Fed President John Williams said Tuesday during the Bloomberg Invest conference in New York, adding he expects tariffs to boost inflation. “I think the current place where policy is is good. I don’t think we need to change it right away.”
Powell may shed light on his outlook when he speaks Friday. Policymakers could also offer more insight on how they expect tariffs and other policies to affect interest rates, prices and growth when they issue updated economic projections after their March 18-19 gathering.
A deciding factor that will shape how officials ultimately respond to tariffs comes down to whether Americans expect elevated inflation to persist, or if they have confidence the Fed will be able to keep those price gains in check.
Some reports suggest consumers’ inflation expectations are edging higher, though St. Louis Fed President Alberto Musalem noted earlier this week that longer-run expectations remain “broadly anchored.”
If expectations for where inflation will be in the long run remain stable, officials may have more leeway to lower rates in the face of a slowing economy.
“They would like to look through the inflation impulse, but they need to see evidence that the credibility is maintained, that long run inflation expectations are stable,” said Gapen, who expects the Fed to lower rates once in the second half of the year.
History Lessons
Last time the economy faced Trump tariffs, the Fed did look through the potential price impact.
In September 2018, the central bank’s economists offered two alternatives to policymakers for managing trade tensions during Trump’s first administration. The staff presented the scenarios for a broad-based tariff increase in that month’s edition of the Tealbook, a document that provides an assessment of and projections for the economy.
Under the first alternative presented, policymakers could respond by lifting interest rates to counter the jump in inflation and spark a “mild” recession. In the second alternative, the response “‘sees through’ this short-lived rise in inflation” and policymakers could instead lower interest rates to support the economy and skirt a recession.
The staff determined that the second alternative “would seem an appropriate response to a tariff hike.” But they noted that would only be true under two conditions: that inflation expectations remained anchored and that the tariffs’ pass-through effect on inflation was relatively short-lived. Officials ultimately cut rates three times in 2019.
Fast forward to now. Policymakers want to maintain the strength of the economy while they work to bring inflation all the way down to 2%.
The economy, while still on solid footing, is beginning to show signs of slowing. Unemployment remains subdued, but so is hiring. And now a barrage of economic policies from the Trump administration — like tariffs and immigration curbs — could not only slow business investment and growth but also raise prices for businesses and consumers.
Some policymakers caution they could face a tough choice between their mandates if downside risks continue to mount before inflation returns to target, though they say that is not their base case.
“It could be appropriate to ignore, or ‘look through,’ an increase in the price level if the impact on inflation is expected to be brief and limited,” Musalem of the St. Louis Fed said Monday. “However, a different monetary policy response could be appropriate if above-target inflation is sustained, or longer-term inflation expectations rise.”
--With assistance from Catarina Saraiva.
(Updates with Bessent comments in seventh paragraph.)
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