A trade war puts pressure on the Federal Reserve
Summary
Lowering interest rates to soften the negative shock risks embedding higher inflation into the economy.
Virtually all economic research and historical experience show that the costs of tariffs, including the reduction of future potential growth, far outweigh any benefits of protecting the U.S. from international competition and bringing jobs home. President Trump’s first-term tariffs failed to achieve their objectives of reducing the trade deficit and increasing domestic manufacturing jobs and proved costly. Now his erratic and unpredictable policymaking on tariffs is heightening uncertainties as households and businesses brace themselves for higher prices and disruptions to production. The falling stock market reflects investors’ understanding of this logic and anticipation of economic losses.
Mr. Trump’s aggressive tariff policies pose another serious risk: The weaker economic activity, higher unemployment and likely increased prices that will result run counter to the Federal Reserve’s dual mandate of 2% inflation and maximum employment. This will strain the Fed’s monetary policy, pressuring it to make short-run decisions that may compound the longer-run costs of the tariffs.
The Fed’s dual mandate is difficult enough to achieve without tariffs. After it extended excessively easy policy to accommodate the $1.9 trillion March 2021 American Rescue Plan—which fueled a surge in inflation—the Fed raised rates aggressively from March 2022 to July 2023. In late 2024, it lowered rates by a percentage point as the economy remained resilient and continued to grow. Now it faces a delicate balancing act. With inflation sticky at 2.8% and an unemployment rate of 4.1%—generally consistent with maximum employment—the Fed hopes that its federal-funds rate target of 4.25% to 4.5% will lower inflation and sustain healthy growth.
This balance is now threatened by Mr. Trump’s policies. His first-term tariffs harmed economic activity and offset the benefits of his deregulations and tax cuts. International trade flattened, and U.S. business imports of capital goods used in production declined.
In response to today’s tariffs, some businesses are indicating they will pass higher costs to consumers. Inflation-weary consumers may push back. The public is confused by Mr. Trump’s convoluted use of tariffs as a weapon of statecraft. It’s one thing to impose trade barriers on China for national-security purposes, but tariffs on Canada, Mexico and Europe make no sense.
The heightened uncertainty is weighing on households and businesses. The Economic Policy Uncertainty Index, developed by economists Scott R. Baker, Nick Bloom and Steven J. Davis, has spiked dramatically since Mr. Trump was elected. Their research shows that past abnormal jumps in the index—such as during the 2008 financial crisis and the Covid pandemic—led to weaker employment and industrial production as businesses slowed hiring and postponed investment plans. Likewise, tariff uncertainties are expected to disrupt supply chains and raise U.S. production costs. There are also worries that they will fuel inflation.
But unlike past spikes in uncertainty, the current surge almost exclusively reflects Mr. Trump’s tariffs and unpredictable decision making. How should the Fed respond to such a policy-induced negative shock to the economy? The Fed tends to react more quickly and aggressively to labor-market weakness and high unemployment than it does to high inflation. Thus, the odds are that it will try to soften the blow of tariffs with lower interest rates and expansionary monetary policy.
But lowering interest rates to mitigate the short-run economic effects of Mr. Trump’s tariffs could boost inflationary expectations and embed higher inflation in the economy. It could also embolden the Trump team to impose more tariffs, further harming economic performance. This would produce stagflation. Monetary ease is incapable of offsetting the economic inefficiencies and distortions created by the tariffs.
History demonstrates the imprudence of this approach. In the 1970s, the Fed under Chairmen Arthur Burns and G. William Miller followed accommodative monetary policies that served to mitigate the negative economic effects of the 1973 and 1979 oil price shocks. This generated higher inflation and inflationary expectations, which harmed economic and financial performance and proved very costly to purge. By contrast, the central banks of Germany and Switzerland kept monetary policy restrictive during the oil shocks, which constrained inflation and more quickly stabilized their economies.
Mr. Trump is betting that the Fed will soften the blow of tariffs by easing monetary policy—and so are interest-rate markets, which are predicting rate cuts. But the Fed’s attempts to do so via accommodative monetary policy would risk higher inflation amid tariff-induced economic inefficiencies, while businesses and consumers must deal with the tariffs’ distortions.
Chairman Jerome Powell has properly emphasized that the Fed will remain independent while determining monetary policy. Congress—in particular, the Senate Banking Committee and House Financial Services Committee—must support the Fed at this critical juncture. All Americans benefit from an independent central bank that pursues stable, low inflation as the foundation of healthy economic growth. The Fed must now be guided by the lessons of history.
Mr. Levy is a visiting fellow at the Stanford University’s Hoover Institution. Mr. Bordo is an economics professor at Rutgers and a distinguished visiting fellow at Hoover. Both are members of the Shadow Open Market Committee.
