How the Fed should deal with US stagflation risks
Caution should continue to be the watchword in Jackson Hole until the impact of Trump’s policies are better understood
Chris Giles
© James FergusonWhat should Jay Powell say about the US economy when addressing the Jackson Hole economic policy symposium this week?
With volatile data showing weak jobs growth and rising inflationary pressure, the Federal Reserve chair needs to signal the central bank is dealing convincingly with this difficult stagflationary tension in the face of sustained criticism from the US president.
There are three ways to look at the US economy just over half a year into Donald Trump’s second term.
Financial markets are taking a traditional demand-side view, using large downward revisions in jobs growth numbers for May and June alongside weaker private spending in the first half of the year to feed their belief that the Fed will cut rates in September.
Equity markets like the prospect of cheaper borrowing costs to juice returns.
Although Trump has demanded far lower interest rates, his administration takes a subtly different stance on the economy because it cannot accept the view that its wayward economic policy might have hit demand.
Treasury secretary Scott Bessent says the Fed should be looking at a half-point interest rate cut in September because “we are going back into an economy we had in the Nineties”, with deregulation and tax cuts boosting output and productivity growth without inflation.
The third, more mainstream view is that the slowdown, alongside rising inflationary pressure, is best explained as the result of poor economic policy.
While the effect of tariffs should not be exaggerated in a country where goods imports represent only around 10 per cent of GDP, they still distort consumer choices and raise US production costs.
The clampdown on migration might have little impact on living standards, but it reduces the level of jobs growth consistent with sustainable inflation.
And higher tariffs risk another inflationary episode with companies raising prices and consumers demanding higher wages.
It is important to recognise that these three views are not mutually exclusive.
Trump’s immigration policies, for example, are likely to damage the supply side because there will be fewer workers, but also might make some people too scared to go out and spend as before, hitting demand.
While the Trump administration has pushed supply-side deregulation, tariffs bring many additional burdens on business.
The answer to which view of the economy is right and what the Fed should do therefore must rest on the economic evidence, which is inevitably inconclusive, yet it points on balance to the central bank continuing a cautious approach with no need to rush to any conclusion on interest rates.
There is very little sign of the supply-side nirvana promised by the administration.
Non-farm output per hour worked grew 1.3 per cent in the year to the second quarter and only an annualised 0.3 per cent rate in the first half of this year.
If we are going to see an economy of the 1990s, the Fed would have to take it all on trust.
That would be unwise when, so far, the slowdown appears more consistent with weak supply than deficient demand.
Although jobs growth was feeble in the second quarter of this year, unemployment was broadly stable, suggesting that whatever is causing economic weakness, the classic signs of corporate or household caution are absent.
This is different from when the Fed cut rates last year as the joblessness rate rose.
At the same time, there is little doubt that underlying inflationary pressure is strengthening, raising the risk that one-off increases in prices from tariffs lead to prolonged inflation.
Corporate surveys show a large majority of companies reporting rising prices of inputs and outputs.
Core producer prices rose in July at their fastest monthly rate since 2022.
Underlying goods and services inflation is rising and exporters to the US are not lowering prices to offset tariffs.
When the Federal Open Market Committee believes that its current monetary policy stance is “modestly restrictive”, its best approach is to take a view on interest rates that is least likely to generate a bad outcome.
If markets are right but the evidence of demand weakness is not quite there, a wait-and-see attitude from the Fed would not be ideal but is unlikely to cause a deep downturn given policy is only modestly restrictive.
The key data point would be rising unemployment.
That would be sufficient for the Fed to cut.
If the Trump administration is right and non-inflationary growth is just about to surge, there are few risks in keeping the monetary stance a little restrictive for now and waiting to cut rates.
After all, if productivity growth has been transformed, the “neutral rate of interest” in which policy is not too tight or loose would rise along with the coming surge in private sector investment.
That would make the current level of interest rates less restrictive without doing anything.
But if the true story of Trump’s economy is one of weaker supply and an inflationary threat, moving soon to cut rates would be damaging.
Allowing inflation to take off twice in a decade would put the Fed’s reputation in grave danger.
That is the risk with loosening policy again before we understand the effects of Trump’s economic policies.
There is a good chance Powell or his successor will take the risk and live to regret it.
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