Federal Reserve Chairman Jerome Powell recently indicated that the Fed has refrained from lowering interest rates due to concerns that the Trump tariffs could spark inflation. Our concern is that Powell and his colleagues on the Federal Open Market Committee are being too cautious and by keeping interest rates too high, too long, could stall the economy.
There’s a worrying symmetry to the Fed’s inaction. Just as it was too slow to raise interest rates (known as “tightening”) in 2022 when inflation skyrocketed, it’s too slow to loosen now that inflation pressures have eased.
The potential threat to the economy comes from the fact that falling inflation, absent a corresponding reduction in interest rates, increases borrowing costs—what’s known as passive tightening. Borrowing costs are critical because borrowing is necessary to fuel factory construction, infrastructure, research and development, and other long-term investments needed for economic growth.
What ultimately matters most is inflation-adjusted interest rates. This represents the real cost of borrowing.
The Fed’s target for the “federal funds rate”—the interest rate banks charge each other for overnight loans and the Fed uses to implement policy—has been between 4.25% and 4.5% since late December. During that time, however, the inflation rate has fallen about 10%, from about 3% to 2.7%. Since the fed funds rate affects interest rates throughout the economy, commercial borrowers are paying a premium compared to previous months.
Normally this would present a good case for loosening monetary policy, which lowers interest rates in the short run. But the tariff threat has complicated matters. It shouldn’t: because contrary to what you may have heard, the effects of tariffs on inflation likely will be small.
In theory, tariffs could raise the economy’s long-term inflation rate. But theory only gets you so far. We need to know how much tariffs will affect matters.
Keep in mind that tariffs are taxes on imports, which account for roughly 14% of the U.S. economy. While there’s great uncertainty about the final tariff rates, which are likely to vary, a safe guess is that taxes on imports from some of our biggest trading partners—Canada, Mexico, the European Union, Japan, South Korea and Taiwan—likely will rise 25 to 30 percentage points. That will certainly push up specific prices.
But will it drag down the economy, as the Federal Reserve Board apparently fears?
It’s hard to see how considering the White House’s ongoing negotiations for trade deals. More likely, the import taxes will slow economic growth by a fraction of a percent—and the inflation impact will be small.
Contrary to President Trumps’ assertions, the Fed’s motivations are almost certainly not political. There are many reasons to object to how Chairman Powell has run the Fed, but by almost any standard he appears to be a conscientious public official doing the best he can at an incredibly difficult job.
Whatever the Fed’s motivations, or reasoning, there is a real risk that Powell and company are falling behind the curve. The most recent jobs report was not bad, but it wasn’t great either—and there are signs that hiring is slowing. Most of the employment growth came from state and local governments and government-adjacent sectors such as health care.
This is concerning because the private economy generates the wealth upon which the public economy depends. Wage growth also is slower than it should be. Given the state of the economy, keeping monetary policy artificially tight could prove very costly.
The Fed’s caution is understandable. Powell and his colleagues got badly burned with the “transitory” inflation fiasco—and whatever their excuses, 40-year-high inflation was indeed their fault.
But past mistakes don’t justify new ones. Trying to overcompensate will do the economy more harm than good. To keep America’s economic expansion going, the Fed should begin easing as soon as possible.
