The Fed is trying—again—to size up Trump

The difficult balancing act was on full display over the last two months. In early November, days after Trump’s election to a second term as president, Powell declared that the central bank wouldn’t set interest rates based on assumptions or speculation about the incoming administration’s policies, including possibly transformative changes to trade and immigration policy.

“We don’t guess, we don’t speculate, and we don’t assume," Powell said at a Nov. 7 news conference.

But the central bank also often says that its interest-rate policies need to be “forward looking"—taking into account projections of future price pressures and employment conditions—because it takes time for changes in borrowing costs to filter through the economy. Powell and his colleagues provide a steady diet of commentary to help investors understand how the Fed might react to any number of economic outcomes.

The Fed cut rates by a quarter point last week, bringing its policy rate down by a full-percentage point since September. But new projections showed officials expect fewer cuts next year, in part because they expect more stubborn price pressures than they previously anticipated.

The most recent meeting “came out much more hawkish than we thought because they did what they said they weren’t going to do: They said they weren’t going to speculate on policies and then a month later they decided to speculate on policies," said Michael Gapen, chief U.S. economist at Morgan Stanley.

Most Fed officials penciled in just two cuts next year and two more in 2026. In September, most officials anticipated at least four cuts next year.

They now expect inflation, excluding volatile food and energy items, to fall to 2.5% next year; previously, they saw inflation declining to 2.2% next year. Moreover, 15 of 19 officials said they see a risk that inflation will be higher than their forecast, up from three officials in September.

The economic projections “made it hard to get around the elephant in the room," said Gapen. “Powell didn’t want to say that, but it’s clearly what the signal is from the committee…. They’re saying, ‘We have to lean against some of this.’"

Inflation has cooled over the last 18 months—thanks mostly to a fortunate combination of supply-chain healing and labor-force growth, including from increased immigration. Even though the economy has grown briskly, price and wage growth have cooled because the supply-side of the economy, or the economy’s ability to supply more goods and services, has also expanded.

Trump has threatened to raise or impose new tariffs on trading partners and to tighten immigration rules, which could boost prices and wages in the short run.

The president’s advisers have said steps to ease regulations and boost energy production could offset the effects of higher goods prices, allowing inflation to continue declining. Scott Bessent, the Treasury secretary-designate, said last month that tariffs wouldn’t allow businesses to raise prices in a sustained fashion.

“Tariffs can’t be inflationary because if the price of one thing goes up, unless you give people more money, then they have less money to spend on the other thing, so there is no inflation," he said on a radio program hosted by Larry Kudlow, a former Trump adviser.

Political antennae

Powell said at a news conference last week that some officials accounted for potential policy changes in their new forecasts while others didn’t. He disputed the idea that the November election had been the primary cause of Fed officials’ more disappointing inflation outlook and instead pointed to recent firmer inflation readings.

The Fed’s inflation projection for the current year has “kind of fallen apart," Powell said. “That might be the single biggest factor."

Behind the scenes, Powell has chafed at public commentary from some of his colleagues that more directly ties potential policy shifts by the Fed to changes in economic policies proposed by the Trump White House, lest it lead Republicans to think the Fed is trying to offset policies it doesn’t like.

Powell has urged his peers privately to be careful in their public comments about directly linking possible policy changes by the White House to a central bank response, according to people familiar with the matter.

That is in keeping with his longstanding effort to maintain a Fed culture that prizes apolitical, sober-minded analysis. Officials can find themselves under a political glare during an election campaign or when a new administration is making transformative policy changes. The effects of potential policy changes by the new administration are also still highly uncertain.

Some central bank officials, however, have hinted at a more abrupt pivot. In recent speeches, governor Adriana Kugler celebrated the swift easing of price pressures over the past year or so and attributed it partly to an influx of workers.

Kugler, who supported the jumbo half-point cut in September amid worries the labor market might be slowing too much, lately suggested the central bank might be in less of a position to ease rates if labor-force growth slows or stops.

While Trump has long expressed a desire for lower interest rates, he hasn’t commented on recent Fed moves. Several people who consult with Trump on the economy aren’t itching for the central bank to keep cutting because they recognize inflation hasn’t been fully vanquished.

The 2018 episode

When Trump escalated a trade war the first time he was president, the Fed ended up lowering rates. Officials feared the hit to business sentiment and investment from a trade war might swamp potential effects of higher prices from tariffs.

But it isn’t clear the Fed would react the same way this time around because the underlying conditions are different.

During Trump’s first term, inflation was low, and consumers and businesses didn’t have any recent memory of being asked to accept notable price hikes.

In 2018, Fed staff modeled the impact of a tariff increase and concluded the central bank could “look through" or hold rates steady while prices rose so long as two conditions held: households and businesses expected inflation to stay low and the price increases flowed through the economy quickly.

Powell cited that briefing, waving it from the lectern at his Dec. 18 news conference, when asked about how the rate-setting committee was thinking about the effects of higher tariffs in the current environment.

“What the committee’s doing now is discussing pathways and understanding again the ways in which tariffs can affect inflation and the economy," said Powell. “It puts us in position, when we finally do see what the actual policies are, to make a more careful, thoughtful assessment of what might be the appropriate policy response."

Trump has also promised to tighten border controls, beginning with mass deportations. Fewer workers could mean less production, weaker demand, and higher wages, but the exact effects are very hard to model.

If the new administration moves forward with policies that reverse recent positive supply developments, economists expect the Fed will simply leave rates where they are as opposed to continuing to lower rates.

“In this environment, you’re not coming from six years of below-target inflation. You’re coming from a few years of being well above target," said Michael Feroli, chief U.S. economist at JPMorgan Chase.

Some analysts say the underlying conditions of the economy will matter greatly in determining how much businesses attempt to push higher costs along to their customers.

“We are at full employment. If you impose a cost-shock, it will get passed through much more than if you’re in a downturn," said Ray Farris, an economist in New York. “The cost shock works its way into the system depending on the stage of the cycle you’re in."

Another wild card: whether an increase in prices gets passed through in one fell swoop or whether companies spread out the increase in tariffs over time. “If companies phase the pass-through, and they don’t do it immediately and completely, it will appear increasingly to the public that there is more of an inflation problem," said Farris.

Write to Nick Timiraos at Nick.Timiraos@wsj.com