The optimal response of the Federal Reserve to the new tariffs initiated by the Trump administration seems to be to ease monetary policy. With the details of these extensive tariffs becoming clearer, attention is shifting to how the Fed and other central banks will react to what President Trump has termed “liberation day” duties.
It’s well accepted that tariffs can harm economic growth and trigger inflation, at least in the short term. The question remains whether central bankers should cut interest rates to support a sluggish economy or raise them to control rising prices.
A working paper from the Minneapolis Fed argues that the best course of action is to ease policy rather than simply maintain rates. Economists Javier Bianchi and Louphou Coulibaly emphasize that stimulating the economy is essential for increasing overall income and enhancing the demand for imported goods.
Their findings suggest that the appropriate monetary response is expansionary, even if it means allowing inflation to exceed the direct effects of the tariffs. This conclusion holds true regardless of whether tariffs target consumption goods or intermediate inputs.
Despite the widespread belief that inflating an already rising inflation rate is risky for central bankers, the authors contend that historical data does not support this notion. Instead, they argue that to mitigate the negative effects of tariffs, the central bank needs to bolster economic activity, create jobs, and increase income levels.
They advise policymakers to be prepared to tolerate some level of overheating in the economy. Currently, Fed officials are taking a cautious stance.
Recent economic projections indicate expectations for two quarter-point rate cuts this year, though some officials have suggested that there may be only one cut. Fed Chair Jerome Powell has indicated that a wait-and-see approach is necessary to gauge the actual impact of tariffs on the economy.
On the other hand, Fed Governor Chris Waller has noted that if the tariffs do not cause significant inflation, they are unlikely to influence his view on monetary policy direction. The market appears to favor a focus on stagnation over inflation, with recent reports indicating high factory gate prices and elevated consumer inflation expectations.
However, bond yields are declining, and interest rate futures are predicting multiple cuts in the near future. Investors seem convinced that if a recession occurs due to these tariffs, the Fed will prioritize stimulating economic growth, aligning with historical patterns.