The Global Week Ahead: Why the Fed’s Not Coming to the Rescue

Next Week's Risk Dashboard

• Longstanding warnings on Trump 2.0 are coming true
• Trump has raised tariffs to 1908 levels…
• …and the FOMC will continue to be patient
• Why the FOMC isn’t coming to the rescue
• Estimating the impact of tariffs on US inflation and unemployment
• US CPI may offer early glimpses ahead of great pressures
• Pre-tariff FOMC minutes to be stale on arrival
• Ditto for the BoC’s surveys
• Central banks on tap: BCRP, RBNZ, RBI, BSP
• Global macro

Chart of the Week

It’s with great dismay that my longstanding narrative that has been warning of the damage a second Trump term would do is coming to fruition. In a pre-election version of this weekly last October, I wrote “Term 2.0 policies risk very high damage to America and the world” and I’ve steadily argued that the administration’s policies would come at a cost to growth, inflation and market stability.

The Trump administration’s actions have returned the tariff rate on US imports to punitive levels not seen since 1908 (chart 1). Even after taking account of some exceptions, the vast bulk of imports into the US from various countries is being taxed (chart 2). As we see the consequences unfold, however, a key debate in the markets is whether, when, and to what extent the Federal Reserve may ride to the rescue of the Trump administration’s trade war and its deleterious effects upon the economy and markets by implementing easier monetary policy. The answers to these questions critically depend upon the outlook for the balance between inflation and full employment. This topic will continue to be front and center in a week that will be dominated by tariffs and US CPI.

WHY THE FOMC WILL CONTINUE TO BE PATIENT

Markets shouldn’t hold their collective breath. The FOMC is likely to be more patient than markets that are pricing a full percentage point of easing by year-end. We presently think the FOMC is on hold throughout the rest of this year. Why?

Tariffs will negatively impact employment while raising inflation. Where the balance between the two lies is highly uncertain. As Chair Powell has noted, the FOMC would respond to a shock that poses conflicting influences on its dual mandate of price stability and full employment by being adherent to what it said in its Statement on Longer-Run Goals and Monetary Policy Strategy (here). Paragraph six spells out how they would act in such an instance:

“The Committee’s employment and inflation objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it takes into account the employment shortfalls and inflation deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.”

As Powell put it, “You think about how far each variable is from its goal and how long it would take to get back. Then ask what do you need to do. If one of them is further away, then you would focus on that one.” In plain English, they would dovishly pivot toward easing if job market conditions deviate from their estimated longer-run 4% neutral unemployment rate and broader assessment of labour market conditions more than inflation deviates from their 2% target. By contrast, they would pivot hawkishly if the opposite were to happen. Should the two be in equal opposition to one another, then the FOMC may be forced into a position that does nothing for some time.

Which narrative comes to dominate is an empirical and data dependent matter with significant uncertainty. That’s why Chair Powell recently stated “It’s just too soon to say what would be the appropriate monetary policy response. We’re waiting for greater clarity before considering further adjustments.”

The answer to which effect dominates is highly uncertain, but an effort can be made to share views on whether the job market or the inflation rate is more likely to deviate from the Federal Reserve’s targets during Mr. Trump’s trade wars. There is no playbook for this as we haven’t dealt with protectionism of this magnitude in over a hundred years and today’s circumstances are vastly different.

One approach is a thorough model-based attempt at estimating the tariff shock to job markets and inflation over time. We are in the midst of doing so as a global forecast refresh that allows for a complete general equilibrium set of consequences to be considered.

And alternative approach can be taken in the meantime by relying upon several studies that seek to estimate tariff effects on both prices and jobs.

PCE Impact—More Inflation This Year

Trump’s tariffs could lift US headline PCE inflation by between 1½% to over 2½% over our baseline projections for the Federal Reserve’s preferred measure of inflation. That would mean rates of inflation that could approach 4–5% as this year unfolds.

This calculation draws upon a good paper by economists at the Federal Reserve Bank of Boston (here). They provide data for import shares of the PCE basket by country (chart 3) and by commodity (chart 4). The combined direct import shares and indirect (imported content in US production) import shares are multiplied by this week’s announced tariff rates by country as shown in chart 5 instead of the assumed tariff rates the cited paper used back in February. The weighted outcome is a lift to PCE of at least 1.5%.

The authors then correctly note that the ultimate impact on prices will depend upon what happens to margins. Key becomes whether margins compress, stay constant, or perhaps even widen and whether they do so in dollar or percentage terms. Depending upon the answer, the inflation shock could be between about 1.5–2.5%. It companies maintain a constant dollar margin while allowing their percentage margin to compress then the inflation shock could be toward the low end of the range. If, by contrast, it’s the percentage margin that is maintained, then the inflation impact could be considerably larger.

In the present context of an economy that is in excess aggregate demand with capacity pressures, it may be that percentage margins are maintained at least at first.

Estimating the Employment Hit

As for the impact upon employment, there are several studies that looked at the effects of tariff rate increases on employment over the 2018 experience (here, here, here). Tariffs could benefit employment in selected sectors that benefit from their protections (such as US steel companies), while harming employment in sectors that are not directly benefited—such as retailers. Studies from the 2018–19 tariff period have shown that they reduced employment by about 1.8% or 220,000 jobs excluding China’s retaliation, or 320,000 jobs (2.6% of the total) including China’s retaliation.

These employment reductions happened when the effective tariff rate on US imports increased from 1.4% to 2.6% for an overall increase of 1.2%. Today’s increase in the average effective tariff goes from 2.3% to about a whopping 24%. The impact on employment now versus the earlier tariff shock may not be a linear relationship that can simply be scaled up. But it’s conceivable that between 4–6 million Americans could lose their jobs because of Trump’s tariffs.

At present levels of employment, this would equate to between 2½% and 4% of total employment in the United States. Assuming no growth in the labour force would mean that the unemployment rate could rise from 4.2% at present and easily cross 6% and perhaps considerably higher while also depending upon how job market attachment and immigration policy evolve.

A Conundrum

Given these outcomes for inflation and unemployment, it’s not clear to me what the FOMC would emphasize, at least for a while. The unemployment rate could be 2½% to 4% above their presently estimated neutral unemployment rate. They may, however, think that the neutral unemployment rate may be higher now because of tariffs. But the inflation rate could also be similarly further away from the 2% inflation target.

Bear in mind that the FOMC would also be concerned about doing anything that would drive inflation expectations higher because of perceived accommodation of a tariff shock.

Amid this uncertainty, the FOMC may be very patient, and treat the matter as an empirical issue to be settled by data, time and further developments. That could take quite a while and so we’re leaning toward removing two cuts from our forecast this year and riding at a constant 4½%.

Eventually, however, the FOMC would be very likely to pivot more dovishly unless there is a rapid reversal in Trump’s trade policies. To do so prematurely could further inflame inflation risk more than estimated. Eventually, however, the hit from tariffs to the economy and to unemployment should swing the US economy away from a positive output gap at present toward net slack emerging in 2026. At that point, the FOMC may be more comfortable restoring the path toward a more neutral policy rate.

Producer Prices Will Also Rise

Empirical research has shown that every 10 percentage point increase in effective tariff rate on US imports raises producer prices by 1% (here). Therefore, since today’s effective tariff rate has gone up by roughly double that assumed amount, the impact upon producer prices is likely to be in the range of 2%. Much less than this will translate into PCE inflation through the selected PPI components that are included within the PCE basket. This impact upon producer prices could assist company margins, at least for a time.

Moral Hazard Problems

Aside from these empirical issues is the matter of emboldening the Trump administration’s protectionist trade policies. The moral hazard that the Federal Reserve could court by easing to insulate against some of the most pernicious effects of tariffs could only encourage greater and/or longer-lived protectionism. Ultimately, that could invoke more damage to the economy and financial markets for longer. The FOMC is likely to focus heavily upon its dual mandate, but the uncertainty around how its variables evolve over time is compatible with not rushing to the rescue of the serious policy error being committed on US trade policy. In short, the Trump administration broke it, and the Trump administration has the primary responsibility to fix it.

Financial Markets

The FOMC would also be mindful toward developments in financial markets. Within reason, the FOMC would likely allow for price discovery to unfold. If financial markets become dysfunctional and illiquid, the FOMC could revert to prior playbooks like during the last regional bank challenges and deploy a separate set of tools to address this. At the time, they established a separate facility and increased liquidity injections while leaving the policy rate untouched.

US CPI INFLATION—EARLY GLIMPSES OF THE FORTHCOMING PRESSURES?

Until these debates get settled, we’re left with the more mundane matter of estimating very short-term inflation. The US updates CPI inflation for March on Thursday. When combined with the next day’s producer price report for the same month, we’ll have enough to form expectations for the Federal Reserve’s preferred PCE inflation report that is due out on April 30^th. Just like how nonfarm payrolls didn’t much matter (recap), CPI probably won’t

I’ve estimated headline CPI at +0.1% m/m SA and 2.5% y/y (from 2.8%). Core CPI that excludes food and energy is estimated at 0.2% m/m SA and 2.9% y/y (3.1% prior). These estimates are somewhat different from the Cleveland Fed’s ‘nowcasts’ 0.1% m/m for total CPI and 0.3% for core CPI.

Seasonal issues are one driver. March is a normal seasonal up-month for core consumer prices (chart 6). Furthermore, recent years have seen more elevated seasonal adjustment factors than prior months of March (chart 7).

Gasoline prices are expected to weigh on total CPI somewhat. New vehicle prices may be a small upside contribution to headline and core CPI with used vehicles offsetting. Food prices are expected to be a minor influence. OER and primary rent are expected to continue rising at a similar pace to the recent trend. CPI core services ex-housing is anticipated to continue to grow with high persistence to the trend since last Summer.

A key factor will be core goods prices and whether then continue to post firmer readings than last summer, if not accelerate on initial signs of tariff pass throughs.

The next day’s PPI is estimated to rise by 0.1% m/m with the core reading up by 0.3%. What counts in PPI, however, are the components that feed into the PCE calculations. The prior month saw large increases in hospital inpatient care.

GLOBAL MACRO—CENTRAL BANKS AND LIGHT INDICATORS

Please see chart 8 for a round up of other global indicator releases that I’ll write more about in daily notes during the course of the week.

We’ll also hear from a number of global central banks this week and further insight will be shared over the course of the week. As a long week winds down, I’d encourage you to have a look at the accompanying Central Bank Watch table for expectations. Stale BoC surveys including measures of inflation expectations (Monday) and stale FOMC minutes (Wednesday) will fade into the background in light of the recent tariff and market developments.

Rate cuts are expected by each of RBNZ (Tuesday), RBI (Wednesday), and the central bank of the Philippines (Thursday), while Peru’s central bank may hold (Thursday).