The Fed, tariffs and the world economy
As recognized by most observers, Federal Reserve Chair Jerome Powell’s Jackson Hole speech leaned into a more dovish approach to interest rates and monetary policy than in previous statements. In his much anticipated address on August 22, he indicated a shifting balance of risks between inflation and employment for the US economy, more evident in recent data pointing to a potentially weakening labor market. Powell stated the change in risks “may” warrant adjusting policy, which was easy to interpret as a hint to a rate cut in September and causing markets to fully price in a cut. Powell’s comments also make additional cuts in 2025 more likely than anticipated, namely from one (as markets expected before Jackson Hole) to two. When Fed chairs open the door for a rate cut, it is usually quite difficult to step back.
However, this more dovish approach should not be considered as a full tack in the Fed policy direction. Powell stressed that this adjustment could occur because monetary policy is currently restrictive, based on the comparison between current Fed rates and the Fed estimates of the US nominal neutral interest rate (i.e. the rate consistent with a neutral monetary policy stance). As a consequence, the Fed will aim to normalize rates rather than become accommodative. This hints that the next rate cut is not the beginning of a series, particularly as Powell stressed that policy is not on a pre-set course and will continue to be based on the incoming data and the balance of risks.
In other words, the Fed chair is deviating slightly from past communication when the central bank had been focusing on its main objective, which remains inflation. Tying rate cuts to job growth would not be the best approach since some of the recent weakness in labor data reflects federal layoffs as well as an April surge in policy uncertainty which depressed the hiring rate – things that monetary policy cannot address. Indeed, though Powell hinted at a September cut, this is not a repeat of the central bank cut by 50bps in 2024. In his recent speech at Jackson Hole, Powell noted that the labor market is in balance and that its recent softening does not signal a significant amount of slack, allowing the Fed to “proceed carefully.”
Unlike other Fed officials, Powell is putting greater weight on the employment side of the mandate because of the one-time boost in the price level from tariffs and anchored long-term inflation expectations. He previously pledged not to fall behind the curve on the labor market, and if the Fed cuts in September as expected, it will be an “insurance cut”. Powell seems to be setting the stage for a gradual approach to normalizing interest rates, maybe one cut at every other meeting this year, although guided by incoming data and inflation expectations.
The Federal Open Market Committee (FOMC), the institution that sets US monetary policy to achieve the Federal Reserve’s statutory mandate of maximum employment and price stability, is likely to have one more member in favor of rate cuts at its September meeting. Stephen Miran, President Trump’s pick to fill the remainder of former Fed Governor Adriana Kugler’s term, went through a confirmation hearing on September 4th, and it appears as though his nomination will get a full vote by the next FOMC meeting in mid-September. Meanwhile, the status of Fed Governor Lisa Cook remains unclear and may not be clarified for a few weeks. Earlier, Trump said he was firing Cook for cause, based on allegations that she made false statements on mortgage applications prior to becoming a Fed governor. Cook has sued, asking the courts to allow her to remain as governor while the case, which will likely be decided by the Supreme Court, moves through the judicial process. An initial hearing on the case concluded without a ruling.
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The euro and the dollar
Breve storia della Fed
So far, the financial market reaction to Trump’s efforts to have more influence on the Fed has been rather subdued. However, the recent announcement that Trump was removing Governor Cook probably contributed to a steepening of the yield curve. A less independent Fed would likely favor more aggressive rate cuts, reflected by lower rates at the front end of the Treasury yield curve, at the expense of higher inflation and inflation expectations, captured by higher rates at the long end of the curve.
It is unlikely that the US dollar’s recent depreciation and the broader sell-off of US assets (leading to the higher rates on US long-term bonds) stems from a loss of faith in the status of the dollar as the global reserve currency. Instead, the sell-off of the US dollar and fixed income markets has been driven more by three developments unique to the tariff shock. First, the hit to demand deriving from the imposition of import tariffs is larger in the US – triggered by an initial rise in inflation – than in the rest of the world, where the demand shock is more limited as long as eventual retaliatory measures are kept to a “reasonable” level or, even better, not adopted at all. Second, international investors were overexposed to US assets, and this episode has prompted some rebalancing. Third, acute policy uncertainty has contributed to the dollar’s short-term decline.
Still, the dollar’s reserve status could be undermined if the current cyclical pressure on US assets develops into longer term, structural pressure. To reach that stage, trade protectionism would need to be exacerbated and accompanied by other drastic policy changes. Specifically, the US would have to adopt measures to directly limit capital flows, building on Section 899 of President Donald Trump’s budget bill (the “One Big Beautiful Bill”), and let US public debt dynamics become unsustainable by refusing to outline a credible consolidation plan in the years ahead. While policy measures in these areas have been floated by the Trump administration, there is still a long way before seeing the dollar’s reserve status being significantly undermined.
In the current economic development, inflation and inflation expectations in the US depend largely on the impact of tariffs on imported goods. So far, the impact has been lower than markets and most analysts expected. This is due to three factors.
On one side it is too early to see prices impacted by tariffs as US importers had anticipated the tariffs by front-loading inventories – several months will be necessary to see the full effect.
As a second factor, it is unlikely that the US administration will push the average tariff rates on imports to levels that would dent significantly the existing value chains. The US manufacturers are heavily dependent on input from abroad and the replacement of such input would not only be painful in the short-term but in most cases would realistically take several years to be implemented. According to Richard Baldwin, the “average effective rate rose from roughly 2% in 2024 to about 7% by April and then doubled to 16% by August. Yet, these increases have not reached levels that would threaten the stability of the US economy.” At the same time, the Oxford Economics baseline forecast expects that CPI inflation in 2025 will be in line with CPI in 2024, with 2026 possibly slightly lower, kept down by lower domestic demand and lower energy prices. However, the eventual implementation of higher tariffs and the prospect of additional Section 232 tariffs on pharmaceuticals, semiconductors, and other sectors imply the risk that higher inflation could prove stickier than anticipated – especially should the Fed adopt a more relaxed monetary policy.
The third factor which helps explain the limited impact of import tariffs on US inflation (as well as growth) is the reduced weight of the value added of manufactured goods in the US economy – a feature common to all advanced economies. The share of manufacturing over the US GDP is around 10% and import tariffs are exclusively addressed to manufactured products. In other words, 90% of the US economy is not touched by import tariffs. Furthermore, not all manufacturing companies require international value chains for their domestic production.
Protectionist measures are detrimental for growth, research, spread of innovation and labor markets. However, despite the huge uncertainty created by US tariffs, there is a growing sense that the global economy and financial markets may be able to live with them, although a few sectors will undergo significant turmoil. The average share of manufacturing over GDP in OECD economies is around 15%. Overall, it is to be expected that the broad macroeconomic impact of higher tariffs (at least as seen so far) on the global economy will be muted and mitigated by supportive fiscal – and to a lesser degree monetary – policy, especially in the US and China.
Nonetheless, the malign effects of tariffs via their squeeze on US households’ real incomes and weaker capital spending as a result of greater uncertainty are only just beginning to be felt. A soft H2 this year will probably be followed by lackluster growth in 2026 – around 2.5% in both years. This will be the two weakest years of growth since 2009 excluding the pandemic of 2020, but it is far from disastrous.
US President Donald Trump’s tariffs herald an era of more fractured trade and greater protectionism, but this is only part of a more general shift in economic policy as governments adopt more activist fiscal policy. However, although the scaling back of fiscal consolidation plans may raise concerns around fiscal sustainability, it is unlikely that these will reach crisis levels, at least for advanced economies. Still, greater use of expansionary fiscal policy may make it tougher for central banks to keep inflation close to target, particularly if geopolitical forces and climate change result in more supply shocks than in the first two decades of the century.
This increases the risk of shorter stop-start economic cycles, in sharp contrast to the long economic cycles of the 1990s and early 21st century. Meanwhile, higher debt burdens and greater economic volatility are likely to prompt term premia on long-term government bonds to climb across advanced economies. Advanced economies’ fiscal plans will not get to the point of triggering debt sustainability panics or sovereign debt crises, at least among advanced economies. Still, the scaling back of plans to narrow deficits is a lost opportunity to put the public finances on a more robust footing.
In addition to higher longer-term yields, more activist fiscal policy will also likely add to inflation volatility, making the job of central bankers to keep inflation stable all the more difficult. What’s more, the greater risk of future supply shocks – due to factors such as geopolitical uncertainty and climate change – will ensure that the period of exceptionally low and stable inflation in the first twenty years of this century is unlikely to be repeated.
More volatile inflation, higher risks of policy mistakes, and slightly slower trend growth increase the likelihood of shorter expansionary periods than seen during the 1990s and early 2000s, perhaps even signaling a return to the stop-start cycles of the pre-inflation targeting era.
