MNI POLICY: Fed Forced Into Hawkish Stance Despite Growth Risk

A new phase of inflationary risks brought about by President Donald Trump's expansive trade war has put the Federal Reserve on high alert, and officials are prepared to respond if price pressures show signs of lasting – even if growth begins to weaken. 

That means holding interest rates in modestly restrictive territory for now. Over time, the prospect of rate hikes might come back into play if signs accumulate that firms, workers and investors expect high inflation to linger for the long run. 

Tariffs pose a threat to both sides of the Fed's dual mandate, hurting growth and jobs, as well as raising prices and – after the pandemic experience and four years of above-target inflation – potentially de-anchoring price expectations. 

Finding itself in this difficult position, the Fed will need to act hawkishly even as it faces increased risks of a downturn and turbulent financial asset prices. By the time tariffs hit jobs, perhaps later this year, officials could pivot to cuts to support the labor market, but only if they are confident their 2% inflation anchor has been preserved. 

INFLATIONARY MINDSET

Consumers are already expecting much higher inflation in the short term, and some businesses say they expect to pass through the bulk of rising costs to customers. They've already started doing so in anticipation of new waves of tariffs.    

One-year ahead consumer inflation expectations rose to 5.0% in the latest University of Michigan survey, the third straight month of an unusually large rise of half a percentage point or more, survey chief Joanne Hsu said. Five-year ahead expectations jumped to 4.1%, the highest in 32 years. (See: MNI INTERVIEW: Inflation Expectations Worrisome For Fed- UMich)

An EY-Parthenon survey of 4,000 executives found 72% plan to pass at least 50% of costs to customers and 31% plan to pass through over 90% of the additional expenses. 

The more firms import supplies from tariff-affected countries including China, Canada and Mexico, the higher their expected price and unit cost growth for 2025, according to an Atlanta Fed analysis of its quarterly CFO survey. 

UPSIDE RISKS 

Fed Chair Jerome Powell at his post-FOMC press conference last month noted inflation has started to move up this year partly in response to tariffs. Goods inflation, which had been in negative territory for some time and typically serves as an offset to higher housing and non-housing services price pressures, accelerated to 0.4% in February. A year ago, it was -0.4%. 

A new model from the Boston Fed that seeks to disentangle the persistent factors driving inflation from temporary ones shows rising price pressures from a contraction in goods supply at the start of the year, likely reflecting anticipatory imports by businesses ahead of the levies. The effect is still small, but bears watching. 

Inflation had already been moving sideways since mid-2024 as the positive supply shock of a surge in immigration petered out. Trump's additional restrictions could put upward pressure on wages in sectors like construction and agriculture that are highly reliant on immigrant labor, creating potential spillover effects elsewhere. Market-based services inflation was 0.39% in March and has been running above core PCE for seven of the last eight months. 

Tariffs, which weaken competition and create misallocations in the economy, will also dampen the other positive supply-side factor of recent months: productivity growth. That could mean a paring back of hopes prevalent late last year that strong growth could co-exist with ongoing disinflation.