As Federal Reserve officials convened in late January, the outlook seemed stable with a robust job market and economic growth recorded in the previous quarter. Although inflation was a concern, it had significantly declined from its peak level over two years ago. However, the current situation has evolved substantially over a mere seven weeks. The Fed, preparing for its meeting on Tuesday and Wednesday under the guidance of Chair Jerome Powell, faces a challenging environment. Inflation continues to persist at a high rate, and the possibility of new tariffs may exacerbate it. Simultaneously, threats of tariffs coupled with significant cuts in government spending and employment have dampened consumer and business confidence, potentially affecting the broader economy and leading to higher unemployment.
The term “stagflation,” which describes the unpleasant mix of high inflation and an underperforming economy, is troubling for central bankers. This scenario is reminiscent of the 1970s in the United States, a period where deep recessions failed to curb inflation. Handling stagflation poses a unique challenge for the Fed because traditional policy responses—raising rates to control inflation or cutting them to stimulate growth—may not be effective if both inflation remains high and unemployment starts rising.
While it’s uncertain if the economy is headed towards stagflation, the Fed is, like businesses and consumers, navigating an uncertain economic landscape. Even a mild form of stagflation would challenge the Fed, as unemployment could rise from its low of 4.1% while inflation remains above the Fed’s 2% goal. “That’s the tangled web they’re in,” noted Esther George, former president of the Fed’s Kansas City branch. Inflation’s persistence is problematic as it complicates the Fed’s dual mandate of maintaining stable prices and maximizing employment.
At the conclusion of their upcoming meeting, Fed officials are expected to maintain the key interest rate at its current level. Post-meeting, they will publish their latest economic projections, likely indicating an anticipated reduction in the benchmark rate twice this year, aligning with the December projections. Last year saw three rate cuts, and the Fed indicated in January that they were in a holding pattern until the economic outlook clarifies.
Investors on Wall Street are betting on three rate cuts throughout the year—June, September, and December—based on futures tracked by CME FedWatch. This is partly due to concerns that economic deceleration may necessitate further reductions. A recent unsettling development for the Fed is the notable spike in inflation expectations reported by the University of Michigan’s consumer sentiment survey, marking the largest rise since 1993.
Rising inflation expectations are particularly problematic because they have the potential to become self-fulfilling prophecies. When businesses and consumers anticipate increased costs, their actions, such as seeking higher wages, can drive inflation upwards, prompting companies to hike prices to counterbalance elevated labor expenses. While the University of Michigan survey’s findings are preliminary and based on approximately 400 responses, with the final report typically comprising 800 responses, they still serve as a warning. Although financial market measures of inflation expectations, as derived from bond prices, have actually decreased recently, the broader implications remain significant.
Recent inflation data presents a mixed picture. The consumer price index experienced a drop last week to 2.8% from 3%, marking its first decline in five months, which is a positive sign. However, the Fed’s preferred inflation metric, expected later this month, is projected to remain unchanged. An increase in inflation expectations presents a dilemma for the Fed, especially since Chair Powell has indicated a willingness to let inflation gradually revert to the 2% target by 2027, owing to traditionally low expectations. Nevertheless, increasing concerns over inflation might pressure the Fed to address it more aggressively.
George expressed concern over these developing inflation expectations, emphasizing the necessity of vigilant monitoring. The last imposition of tariffs by President Trump in 2018 and 2019 had a limited impact on inflation partly because they were not as comprehensive as current proposals and included exemptions such as those for steel and aluminum. However, given the recent challenging inflation period, there’s more apprehension towards price increases among Americans.
In earlier remarks this month, Powell noted that tariffs could have a transient pricing impact rather than ongoing inflationary pressure, although persistent or significant tariff hikes could alter the scenario. “What really does matter is what is happening with long-term inflation expectations,” Powell remarked, highlighting the significance of these expectations just before the sharp rise documented in the University of Michigan survey.
