Fed confronts lose-lose scenario amid haphazard tariff rollout

How the Fed negotiates tricky communications around these trade-offs will be front and center at officials’ two-day policy meeting this week.

Fed Chair Jerome Powell and his colleagues are on track to extend their wait-and-see stance on cutting interest rates and strategize how to refine it. This calculated patience reflects officials’ determination to avoid prematurely abandoning their inflation fight.

The problem for the Fed amounts to a goalkeeper’s dilemma: Dive right to address inflation by keeping rates where they are, or dive left to counter weaker growth by cutting rates. “We’ll make what will no doubt be a very difficult judgment," Powell said last month.

Acting early to cushion the economy against a slowdown risks adding to short-term inflation pressures from tariffs or shortages.

“This is not going to be a cycle where the Fed pre-emptively cuts because there’s a forecast of a slowdown. They’re going to actually need to see it in the tangible data, in particular the labor market," said Richard Clarida, who served as Powell’s second-in-command for three years and is now a senior adviser at bond giant Pimco.

Waiting for that economic weakness to show up means tolerating risks of a deeper recession.

“Over seven years, the Powell Fed has a track record of waiting to be very sure about the data and then going very fast. I would imagine if you see a notable deterioration in the labor market, at that juncture the Fed will be prepared to move," said Lael Brainard, who served as Fed governor from 2014 until 2023, including as vice chair during her last year.

Sometimes, the Fed sets interest rates with a focus on maximizing good outcomes. Officials did this last year when they cut rates because inflation was declining.

Other times, the central bank makes decisions with a focus on minimizing the worst outcomes. That was the case in 2022-23. Back then, they hiked rates aggressively, risking a recession, to prevent high inflation from growing entrenched.

Tariffs could force them into the latter course. Taxes on imports could push up prices in the short run while the uncertainty generated by their abrupt implementation could slow economic activity, delivering a whiff of stagflation. The risks of higher prices could make the Fed reluctant to pre-empt economic weakness by cutting rates. Instead, officials could focus initially on making sure a one-time rise in prices doesn’t fuel more-persistent increases.

One open question is how decisively they will respond if concrete evidence of a deteriorating job market emerges. The case for cushioning the economy with lower rates would build the more unemployment goes up.

An important challenge will be determining the duration and magnitude of anticipated price increases stemming from tariffs and potential supply disruptions.

Fed officials say that consumer and business expectations of inflation are self-fulfilling and therefore play a crucial role in determining what happens to prices. If consumers and businesses expect inflation to eventually decline, those expectations are “anchored," and the costs of getting inflation down are relatively low.

If unemployment rises and the Fed considers cutting rates, “the constraining consideration will be how much has inflation actually moved up," said Brainard, who was a top adviser to President Joe Biden from 2023 until January. Those constraints have worsened, compared with five years ago, because the economy has been through a period of very high inflation recently.

“You have to be at least a little cognizant—and the Fed certainly appears to be—that inflation expectations could be somewhat less well-anchored," said Brainard.

Complicating matters, Trump has signaled his strong distaste for the emerging strategy by Powell, mocking him as “Mr. Too Late."

In addition to challenges over how to set rates, Powell faces delicate deliberations over how to communicate potential responses.

Sounding more dovish—or willing to cut rates—might not do anything to pre-empt a slowdown that is caused by tariff-induced cost increases or uncertainty. Sounding hawkish—or vigilant against inflation risks—could actually influence price- and wage-setting behavior.

Former Fed Vice Chair Lael Brainard says she believes the central bank would consider cutting rates if a ‘notable deterioration’ occurs in the labor market.Fed governor Christopher Waller says he doesn’t think tariffs will yield persistent price pressures.

“Even if I were thinking I want to look for a way to cut, I would talk hawkish because I want to keep these inflation expectations anchored," said Robert Kaplan, a former Dallas Fed president.

Fed officials agree that rate cuts are inappropriate until they see concrete signs of slower consumer spending and higher joblessness.

But differences are flaring over how confident officials can be that price increases from tariffs and shortages will be temporary. That could determine how fast and how aggressively officials will respond to any job-market deterioration.

Fed governor Christopher Waller says tariffs won’t raise prices beyond this year. He stands alone in publicly advocating that the central bank should be on its front foot to pivot toward supporting growth. Four years ago, the Fed was slow to reduce stimulus when prices were rising, misdiagnosing the price increases as “transitory" and holding rates low for too long.

It would “take some courage to stare down these tariff increases and prices with the belief that they are transitory" after the Fed’s humbling misjudgments, Waller said recently.

But he described today’s situation as fundamentally different from 2021’s pandemic-reopening shock, which was marked by broad imbalances in goods, housing and labor markets. Today, a continuing slowdown in labor demand and wage growth provides no mechanism to nourish higher prices beyond the initial tariff-driven increase in goods prices, he said.

Several of his colleagues, including a few who weren’t at the Fed when the central bank raised rates aggressively in 2022, aren’t willing to be as dismissive of inflation risks. “I would rather be slow and move in the right direction than move quickly in the wrong direction," Cleveland Fed President Beth Hammack said in a speech last month. She took the Fed job last year.

Containers are unloaded from a vessel at a marine terminal in Philadelphia. The abrupt implementation of tariffs could slow economic activity.

Their skepticism stems from two concerns: worries that higher inflation expectations will make it much more painful to bring down inflation and fears that supply disruptions could amplify price pressures beyond simple tariff pass-throughs.

“Will the demand destruction ultimately help offset the impact of cost increases? The truth is, it’s very difficult to predict at this point," Kaplan said.

In an environment where costs are rising not only from tariffs but also from shortages, the Fed could initially exacerbate cost pressures by lowering rates without relieving stress on the economy, said Eric Rosengren, who was president of the Boston Fed from 2007 to 2021.

Rosengren said he could easily imagine two or three Fed meetings where the central bank doesn’t act. Lowering rates makes more sense when the economy is deteriorating because low rates can counteract weak demand. Low rates can’t do much about disrupted supply chains. The Fed could need to make larger, half-point cuts once demand is weakening, Rosengren said.

Then-Boston Fed President Eric Rosengren with Powell in 2019. Rosengren says it is possible the Fed won’t act for two or three meetings.

If not for the threat that tariffs were going to send up prices in the short run, the Fed would be much more likely to be moving already to lower interest rates.

“The Fed is sometimes late. That’s true," said Kaplan, now vice chairman at Goldman Sachs. “There are times it is prudent to be patient and run the risk of being late."

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