High inflation is stoking fresh debate about how the Federal Reserve should respond to President Trump’s sweeping plans to reorder the world economy through tariffs, leading to questions about whether old playbooks still apply.
On Saturday, Mr. Trump is poised to impose 25 percent tariffs on imports from Mexico and Canada as well as an additional 10 percent tariff on Chinese goods. That move comes on the heels of threats to impose hefty tariffs on Colombia, which were rescinded after its government complied with Mr. Trump’s demands to accept deported migrants.
Howard Lutnick, Mr. Trump’s nominee to oversee the Commerce Department and trade, said at a confirmation hearing on Wednesday that he favored “across-the-board” tariffs that would hit entire countries.
The volume of trade policy proposals is making the Fed’s already tricky job even more difficult and sowing uncertainty about what to expect from the central bank as it tries to fully wrestle inflation back to more normal levels.
Tariffs are broadly seen by economists and policymakers as likely to stoke higher prices for U.S. businesses and consumers at least initially, and over time weigh on growth. That, as well as Mr. Trump’s plans to also enact mass deportations, steep tax cuts and reduced deregulation, has complicated the path forward for the Fed, which is debating how quickly to resume rate cuts and by what magnitude after pressing pause this week.
What comes next is far from clear, leaving central bank officials to parse playbooks both old and new to formulate the right strategy.
“The Fed has every intent of following the monetary policy manual that tells you to look through one-time price level shifts, like tariffs, but I worry that reality is messier,” said Ernie Tedeschi, director of economics at the Yale Budget Lab and a former top economic adviser in the Biden administration.
“It will be hard for them to distinguish between different inflationary pressures in the data this year, whether tariffs, immigration, deficits, or non-policy factors,” he said.
The Fed grappled with many of these same issues during Mr. Trump’s first term in office. By 2018, the United States had imposed stiff tariffs on China that were met with retaliatory measures on U.S. products. The trade war upended supply chains and caused businesses across the country to retrench. U.S. importers absorbed much of the increased costs, but consumers ended up paying more for certain products, too.
Transcripts of Fed meetings from that period show that officials were predominantly concerned about the likely hit to growth caused by plummeting business sentiment and a pullback in investment, rather than what they thought would be a one-time but permanent increase in prices.
The idea was that unless there were signs that price pressures were becoming more persistent and that households and businesses were beginning to expect more inflation, the Fed did not need to respond with higher rates.
That view informed the Fed’s decision in the middle of 2019 to deliver cuts that lowered interest rates by 0.75 percentage points, which Mr. Powell billed as an “insurance” policy against flagging economic activity.
Richard Clarida, the former vice chair of the Fed who was involved in formulating the central bank’s response at the time, defended the decision. He said that inflation back then was consistently below the central bank’s 2 percent goal. Also, the potential knock to growth could have been substantial as companies globally turned downbeat.
“We didn’t know what the counterfactual would be,” if the Fed had not done it, he said in an interview.
Today’s circumstances could not look more different, as Mr. Powell acknowledged to reporters at a news conference this week. The legacy of the worst inflation shock in decades still looms large. Interest rates, which were raised above 5 percent to tame rapid inflation, remain higher than prepandemic levels. Prices for groceries and other staples, while not rising as quickly, also remain elevated.
At the same time, the economy has proved extraordinarily resilient, even with high interest rates.
As a result the Fed, after cutting rates by a percentage point in 2024, is in a holding pattern, with its policymakers waiting to see “real progress on inflation or some weakness in the labor market.”
Importantly, while expectations of future inflation among households and businesses have more or less stayed in check, there are early signs that may be changing. According to recent surveys — including a long-running one by the University of Michigan — consumers began to brace for forthcoming price increases as a result of Mr. Trump’s plans to ratchet up tariffs. Some said they planned to buy products in advance to get ahead of expected policy changes, too.
A separate survey conducted in December and January found that consumers were already moving up purchases and stockpiling goods in anticipation of future price increases.
“American consumers on average are pretty aware of the fact that, through higher consumption prices, ultimately they will bear the biggest share of tariffs,” said Michael Weber, a University of Chicago economist who commissioned the survey with two coauthors.
Sure enough, the survey also found that business owners expect to pass the cost of tariffs on to customers. That may be easier to do because consumers already expect that outcome, Mr. Weber said.
Consumers’ expectations “will make the life of the Federal Reserve more complicated,” Mr. Weber said, because it makes tariffs less of a one-off event. If consumers come to anticipate faster price increases, that makes businesses more likely to raise prices — in effect, a self-fulfilling prophecy.
The issue could become even more pronounced if Mr. Trump adopts a gradual approach to putting tariffs in place, warned Matthew Luzzetti, chief U.S. economist at Deutsche Bank.
“That could be helpful to allow consumers and businesses to adjust,” he said. “But I think it complicates the picture for the Fed, because it means that it’s not a one-time price level shock, it’s a rolling price-level shock that could put inflation expectations at greater risk.”
There are reasons to think that the old approach is not entirely moot, however. Earlier this month, one governor, Christopher J. Waller, stood by his call for further rate cuts this year, saying that he did not expect tariffs to have a “significant or persistent effect on inflation.”
Mr. Clarida, who is now at Pimco, said that other factors could offset some of the inflationary pressures, especially if the dollar, as expected, strengthens against foreign currencies. That could also provide a boost to U.S. importers if foreign companies are forced to reduce costs to maintain a competitive edge. Retaliation from other countries would also slow demand for U.S. exports, creating a drag on growth. Taken together, “the old playbook of looking through it may work,” he said.
Mr. Powell also hinted at this week’s news conference that a reordering of supply chains and trade relations could help to blunt the inflationary impact as well, saying that the “footprint of trade has changed,” with less concentration in China and more manufacturing done elsewhere.
Of course, economists warn that universal tariffs of the kind that the Trump administration is promoting would challenge that view.
Amid this uncertainty, the range of possible outcomes for the Fed’s policy settings is enormous. Mr. Luzzetti’s team believes elevated inflation will force the central bank to abstain from cuts for all of 2025.
Yelena Shulyatyeva, senior U.S. economist for the Conference Board, thinks the pause will be shorter, with the Fed picking back up in the second half of the year and eventually lowering rates by 0.75 percentage points given the possibility that tariffs “could impact growth in a major way.”
Seth Carpenter, a former Fed economist who is now at Morgan Stanley, forecasts the Fed to cut in March and June before going on an extended pause as the effects of Mr. Trump’s policies start to crop up in the economic data.
“The constellation of outcomes is really tricky,” he said, especially once other policies like deportations of migrants are factored in.
“Both of those have some inflationary effects and both of those have meaningful negative effects on growth, so it’s going to put the Fed in this awkward bind as to how to react,” he said. “Ultimately, in our forecast, negative growth wins out, and we get much slower growth in 2026 because of it.”
Ben Casselman contributed reporting.