- Risks to the downside for growth and the upside for prices have both increased
- If growth disappoints and short-term inflation rises due to tariffs, the Fed will prioritize the employment element of its mandate
- As long as longer-term inflation expectations remain anchored, this will allow the Fed to look through short-term price increases
If the economy slows and inflation stays elevated – or even rises – as we move deeper into the year, which side of its dual mandate will the Fed prioritize? Fedspeak since the last FOMC seems to us to be divided, with some officials emphasizing inflation and possible upside risks to already elevated levels, while Chair Powell, in his post FOMC press conference, indicated that rates could come down or stay where they are, notably avoiding any mention of potential higher rates. Our view comes down to long-term inflation expectations. If they remain anchored, even in the face of short-term price increases due to tariffs, we think the Fed would be more inclined to err on the dovish side if growth begins to disappoint.
Let’s first discuss inflation. Short-term inflation expectations have indeed risen, as measured by both market- and survey-based indicators. This is entirely reasonable and intuitive. Prices will almost undoubtedly rise as tariffs are passed on by importers. Whether they are expected to continue rising beyond the short term – in other words, whether price increases become persistent inflation – would ultimately be seen in inflation expectations beyond a few years forward. In orthodox central banking, these interim price movements may not need to be confronted with tighter policy. Exhibit #1 above shows the “inverted” term structure to inflation expectations across a range of sources, ranging from consumer surveys (University of Michigan and the New York Fed), the FOMC itself (the Summary of Economic Projections) and forecasters (Bloomberg consensus). In all cases, inflation is expected to be higher in the short term, but lower in the long term.
Furthermore, tighter policy would probably prove ineffective in offsetting price pressures that are ultimately due to higher taxes (in this case on imported goods) and exogenous to the inner workings of the economy. If anything, tighter policy could further weaken what would already be an economy on its backfoot due to the tariff shock.
Speaking of the economy being on its backfoot, this brings us to the growth side of the Fed’s dual mandate. Sentiment indicators, both consumer and business, are weakening dramatically – especially forward-looking elements of these surveys. Hard data – that is data which actually measure activity and output – are still holding up and it’s also well- known that “soft data” do not have a perfect track record in predicting eventual outcomes. Nevertheless, the softness in risk assets, the downgrades
