Trump Forces a Fed Guessing Game
His immigration policies and tariffs will suppress the economy, but how severely and for how long?
By Mickey D. Levy
Photo: Chad CroweEven before the weak August jobs report and the recent large downward revisions of employment, the Fed signaled that it will likely lower interest rates at this week’s meeting.
Financial markets have priced in several rate cuts.
But is this the right monetary policy?
While inflation remains sticky and well above the Fed’s 2% target, the labor market is weakening due to President Trump’s tariffs, immigration clampdown and related uncertainties.
How should the Fed strive to achieve its dual mandate of 2% inflation and maximum employment when misguided policies are pushing the economy in the wrong direction?
These questions pose tough issues, particularly given Mr. Trump’s threats to the Fed’s independence.
The Fed’s recently adopted Statement on Longer-Run Goals and Monetary Policy Strategy is akin to its original 2012 strategic review, which established 2% inflation and maximum employment as the central bank’s dual mandate.
The Fed wisely dropped favoring higher inflation and prioritizing employment as it did in its 2020 Strategic Plan.
But the Fed’s current forward guidance that it will lower rates suggests that it is still prioritizing employment over price stability.
Doing so may involve longer-run costs.
Compare the current situation to the years before the Covid pandemic.
Inflation is now further above its 2% target than it was below 2% during 2016-2019.
The same is true of market-based measures of inflationary expectations.
Personal consumption expenditure inflation is now 2.6%, or 2.9% excluding food and energy.
Consumer price index inflation—the best measure of consumers’ out-of-pocket expenses—is 2.9%, or 3.1% excluding food and energy.
During the pre-Covid years, measured December to December, both headline and core PCE inflation averaged 1.7% while CPI inflation averaged 2%.
During that earlier period, market-based five-year inflationary expectations averaged 1.7%; today they hover near 2.4%.
In 2019-2020, the Fed’s strategic review was driven by its overwhelming concern that if PCE inflation remained below 2%, inflationary expectations risked collapsing.
Combined with its estimate that the natural real rate of interest had fallen, the Fed feared that if rates fell to zero, it wouldn’t be able to effectively ease monetary policy in response to an economic downturn.
Its perceived fears of that effective lower bound led it to favor higher inflation and more stimulus to boost employment.
The Fed argued that if inflation rose persistently above 2%, it would know what to do—tighten monetary policy.
The Fed now downplays its earlier fear of the effective lower bound and its need for asymmetric interpretation of its mandated objectives.
Nevertheless, the central bank is on the verge of easing monetary policy when inflation is a problem.
But there’s another wrinkle.
President Trump’s tariffs and immigration policies are undercutting two pillars of economic growth: labor supply and capital formation.
Businesses have cut hiring while the immigration clampdown has constrained the labor supply.
Jobs markets have lost some of their mobility and dynamism that historically fostered productivity.
Businesses are postponing investment because of uncertainty.
Employment in manufacturing continues to decline.
Although companies are trying to contain operating costs and limit the tariffs’ effect on their product prices, consumers likely face higher prices of imported goods.
These are the sad consequences of misguided economic policies.
That puts the Fed in an awkward position.
It has acknowledged that the tariffs and immigration policy are harming the economy.
But the Fed can only guess at the timing, magnitude and persistence of the effects of Mr. Trump’s misguided policies.
Economic modeling is at the mercy of uncharted nasty supply shocks.
Lowering rates could help support aggregate demand but that wouldn’t offset the distortions and inefficiencies imposed by the negative shock of tariffs, immigration policy and uncertainty.
The Fed correctly perceives that the tariffs should have a one-time effect on inflation, but that effect can take a while to work through inventories, production processes and product prices.
The central bank’s current view that policy is restrictive is based on its assessment that the inflation-adjusted Fed funds rate is well above its estimate that the natural real rate of interest is close to 1%.
But without the recent negative effects of Mr. Trump’s policies, the economy has been quite resilient, and the natural real rate of interest may be closer to 2%, suggesting that current policy is just about right.
Too much monetary easing could undercut the Fed’s inflation-fighting credibility, generating more persistent inflation, raising bond yields and harming the U.S. dollar.
Monetary easing may provide a runway for other misguided policies that undercut the economy and America’s international standing.
The Fed should ignore what markets (and the president) want and carefully consider the risks of lowering rates.
Mr. Levy is a Visiting Fellow at the Hoover Institution and a member of the Shadow Open Market Committee.
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