MNI POLICY: Fed Cut Impetus Fades Alongside Recession Fears

Worries that the worst-case scenario for tariffs would lead to a sudden stop in U.S. economic growth are gradually fading, further reducing the case for the Federal Reserve to cut interest rates this year as uncertainty about the inflationary effects of volatile trade policies remains high.

FOMC members have said repeatedly that monetary policy is well-positioned to react to risks of either more persistent inflation or slower-than-expected growth. Their wait-and-see attitude is being reinforced by the on-again off-again nature of President Donald Trump's tariffs strategy, evidenced by the major blow Wednesday when the U.S. Court of International Trade blocked Trump's actions to impose reciprocal and fentanyl-related tariffs using the International Emergency Economic Powers Act. 

Officials see their benchmark rates “in a good place" at 4.25-4.5% for an economy and labor market that remain solid, so reversals of reciprocal tariffs reduce the chances of an abrupt downturn and thus relieve pressure to lower borrowing costs.

The Fed’s business contacts are nervous but not necessarily resigned to a downturn, though questions persist as to how long the administration's policy about-faces can continue before uncertainty itself becomes a drag on the outlook. Like the Fed itself, many businesses are frozen in place for now, delaying key investment and hiring decisions until there is more clarity out of Washington.

The problem, for both policymakers and businesses, is that the longer the trade war and the theater surrounding it drags on, the more the much-hoped-for day of clarity is delayed – meaning the likelihood of a Fed rate cut also gets pushed back. (See MNI INTERVIEW: Fed Cuts Start In Q4 As Tariffs Weigh -Crandall)

NO PREEMPTION

The Fed is particularly skeptical of the possibility of cutting rates preemptively, as has been suggested by Trump himself, in part because it was so recently burned by the inflation surge following Covid. (See MNI INTERVIEW: Fed Facing Stagflation Risk- Ex-NY Fed Adviser)

At the time, Fed officials were seen as missing the glaring signs that inflation was getting out of control, which arguably allowed price pressures to rise more drastically than they otherwise would have.

This has left inflation expectations vulnerable to unanchoring, as evidenced by the recent spikes in short-term expectations of businesses and consumers in response to the trade volatility. Consumers in the University of Michigan survey indicated their one-year inflation expectations jumped to 7.3% in May from 6.5% in April.

Minutes from the Fed’s May meeting said “almost all participants commented on the risk that inflation could prove to be more persistent than expected. Participants emphasized the importance of ensuring that longer-term inflation expectations remained well anchored, with some noting that expectations might be particularly sensitive because inflation had been above the Committee's target for an extended period.”