Until a few months ago, the Federal Reserve appeared close to achieving something that many doubted was possible. The economy looked on the cusp of a “soft landing,” a situation where inflation was headed back to the central bank’s 2 percent target without a recession. That put the central bank on track to steadily lower interest rates until borrowing costs reached a level that neither revved up growth nor slowed it down.
President Trump’s global trade war has thrown a wrench in those plans. Facing extreme uncertainty about the economic outlook, the central bank has put further interest rate cuts on hold until it has a better sense of how tariffs will affect the economy.
What policymakers are trying to sort out is whether they should be more concerned about the hit to growth that is expected from these levies or the probable boost to consumer prices. The “nightmare scenario,” according to Donald Kohn, the former vice chair of the Fed, is one in which inflation rises at the same time that the economy falters, a combination that carries the whiff of stagflation.
Making that assessment is by no means a straightforward exercise. Much will depend on how long the tariffs are in place, how other countries retaliate, and how consumers and businesses adapt. Officials are also keeping close tabs on other aspects of the Trump administration’s economic agenda, including steep government spending cuts, immigration restrictions and deregulation. Tax cuts are also on the docket, but because those require congressional approval, their timing and scope remain unclear.
At this stage, the economic data presents a mixed picture. Growth in the final quarter of last year was solid and the labor market has yet to show real signs of weakness. The unemployment rate, at 4.1 percent, remains historically low and layoffs have yet to rise in a material way.
Most Americans do not expect this to last. According to recent sentiment surveys, the mood has significantly soured on the outlook because of Mr. Trump’s policies. Consumers now expect slower growth, higher unemployment and resurgent inflation.
The big question for policymakers is whether this will actually materialize. Sentiment surveys tend to be unreliable indicators of future economic activity, and there are reasons to have reservations about recent readings of inflation expectations.
So far, the spike is captured most directly in one measure published by the University of Michigan, but it’s a gauge that tends to be distorted by partisan biases. Jerome H. Powell, the Fed chair, recently called it an “outlier” given that other measures based on government bond markets, for example, have not shifted as significantly.
Still, Fed officials are hesitant to ignore these signals altogether, especially since the anxiety jibes with a lot of what they are hearing when they speak to businesses around the country. That kind of local outreach has become increasingly important for the Fed as it seeks a better handle on how the economy is evolving at a time of intense unease.
From Detroit Lakes, Minn., to Manchester, N.H., business leaders have warned that they have little choice but to raise prices for their customers because of tariffs. They worry that doing so will mean less demand overall, which will weigh on profits. Many have postponed planned investments and pulled back on hiring for now.
Thomas Barkin, president of the Richmond Fed, recently likened the situation to driving through “‘zero visibility, pull over and turn on your hazards’ type of fog.”
Businesses “aren’t pulling back, but they’re not pushing forward either. They’re ‘on pause,’ ‘on hold,’ ‘frozen’ or ‘paralyzed’ until the fog lifts. Those are their words,” he said in a speech last week.
If the economy does start to crack, the Fed’s policy decisions are poised to become much more difficult. Progress on taming inflation was already stalling before Mr. Trump returned to the White House, leading officials to scale back as early as December on how much they thought they could lower interest rates.
The prospects that tariffs will ignite additional price pressures risks hamstringing them even further, likely pushing out the timing of when they will restart interest rate cuts. It also may mean that the bar for cuts has moved higher. That means it will take a notable deterioration in the labor market before they can take action.
Economists across Wall Street have raised their forecasts for a recession partly because of this bind the Fed may soon be in as a result of Mr. Trump’s tariffs. Goldman Sachs now sees a 35 percent chance of a recession over the next 12 months, up from 20 percent previously. They expect the central bank to lower interest rates three times this year, beginning in July.
