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Fed could find itself in a policy Catch-22 if tariffs spike inflation

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Flags outside the Fairmont Royal York in downtown Toronto, Feb. 3, 2025. 

Andrew Francis Wallace | Toronto Star | Getty Images

A complicated scenario is emerging surrounding the tariff drama that could put the Federal Reserve in an uncomfortable Catch-22, unsure whether to use its policy levers to tame inflation or boost growth.

With many bridges to cross yet in President Donald Trump‘s efforts to use the levies as a tool both of foreign and economic policy, the central bank will have a delicate balance to strike.

Many economists expect the tariffs both to raise prices and shave the pace of gross domestic product, with the main question being a matter of degree on the extent of any need for Fed policy adjustments.

“Maybe you get that price shock and maybe it’s offset by the dollar going up vs. the currencies of the countries subject to tariffs. But just really the long-term effects tend to be negative for growth,” said Kathy Jones, chief fixed income strategist at Charles Schwab. “You put that combination together and it puts the Fed in a real bind.”

There are a lot of moving parts happening in the dispute Trump is having with China, Canada and Mexico, the three leading U.S. trade partners. As things stand now, threatened duties against Canada and Mexico have been postponed as the president negotiates with leaders of those governments. But the situation with China has quickly escalated into a tit-for-tat conflict that has markets on edge.

A different history

That tariffs cause higher prices is practically an article of faith for economists, though the historical record provides less certainty. The Smoot-Hawley tariffs in 1930, for instance, actually proved to be deflationary as they helped worsen the Great Depression.

When Trump launched tariffs in his first term, inflation was low and the Fed was raising rates as it sought a “neutral” level. A manufacturing recession ensued in 2019, though one that did not spread to the broader economy.

This time around, the targeted tariffs that Trump had previously used have been replaced by the threat of blanket duties that could change the monetary policy calculus. Schwab projects that the tariffs at full strength could cut 1.2% off GDP growth while adding 0.7% to core inflation, pushing the latter measure above 3% in the months ahead.

Trump's willing to take some equity stress to reach policy goals, says 3Fourteen's Warren Pies

Broader tariffs “have both more price impact and more growth impact down the road,” Jones said. “So I could see [the Fed] staying on hold longer, with the threat of tariffs hanging over the market and maybe seeing these price increases and then having to pivot to easing later in the year, or next year, or [whenever] that growth impact shows up.”

“But they’re definitely in a tough spot right now, because it’s a two-sided coin,” she added.

Indeed, markets largely expect the Fed to hold tight for at least the next several months as policymakers observe the reality against the rhetoric on tariffs, along with looking for the impact from a full percentage point of interest rate cuts in the final four months of 2024.

If any of the parties blink on tariffs, or if they are less inflationary than thought, the Fed can go back to focusing on the employment side of its dual mandate and pivot away from inflation concerns.

“They’re very comfortably on hold right now, and the back and forth on tariffs won’t impact that, especially since we don’t even know what they’re going to look like,” said Eric Winograd, director of developed market research at AllianceBernstein. “You’re talking multiple months before this will meaningfully impact their thinking.”

‘A lot of uncertainty’

Winograd is among those who think that while tariffs could result in one-off boosts to some prices, they will not generate the kind of underlying inflation that Fed officials look at when making policy.

That matches some of the recent statements from Fed officials, who say that tariffs are likely only to affect their decision-making if they generate a full-blown trade war or somehow contribute to more fundamental supply or demand drivers.

“There’s a lot of uncertainty about how policies unfold, and without knowing what actual policy will be implemented, it’s just really not possible to be too precise about what the likely impacts are going to be,” Boston Fed President Susan Collins told CNBC in an interview on Monday. From a policy perspective, Collins said her current stance is to “be patient, careful, and there’s no urgency for making additional adjustments.”

Market pricing is still pointing to a likely Fed rate cut at the June meeting, then possibly one more quarter percentage point reduction in December. The Fed last week opted to hold the federal funds rate steady in a range between 4.25%-4.5%.

Winograd said he sees a scenario where the Fed can cut two or three times this year, though not starting until later as the tariff situation plays out.

“Given how insulated the U.S. economy generally is from trade frictions, I don’t think it moves the Fed needle very much,” Winograd said. “The market is presuming too mechanical of a reaction function from the Fed where if they see inflation go up, they have to respond to it, which simply isn’t true.”

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Economics

Inflation rate slipped to 2.1% in April, lower than expected, Fed’s preferred gauge shows

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Inflation rate slipped to 2.1% in April, lower than expected, Fed’s preferred gauge shows

Inflation barely budged in April as tariffs President Donald Trump implemented in the early part of the month had yet to show up in consumer prices, the Commerce Department reported Friday.

The personal consumption expenditures price index, the Federal Reserve’s key inflation measure, increased just 0.1% for the month, putting the annual inflation rate at 2.1%. The monthly reading was in line with the Dow Jones consensus forecast while the annual level was 0.1 percentage point lower.

Excluding food and energy, the core reading that tends to get even greater focus from Fed policymakers showed readings of 0.1% and 2.5%, against respective estimates of 0.1% and 2.6%.

Consumer spending, though, slowed sharply for the month, posting just a 0.2% increase, in line with the consensus but slower than the 0.7% rate in March. A more cautious consumer mood also was reflected in the personal savings rate, which jumped to 4.9%, up from 0.6 percentage point in March to the highest level in nearly a year.

Personal income surged 0.8%, a slight increase from the prior month but well ahead of the forecast for 0.3%.

Markets showed little reaction to the news, with stock futures continuing to point lower and Treasury yields mixed.

People shop at a grocery store in Brooklyn on May 13, 2025 in New York City.

Spencer Platt | Getty Images

Trump has been pushing the Fed to lower its key interest rate as inflation has continued to gravitate back to the central bank’s 2% target. However, policymakers have been hesitant to move as they await the longer-term impacts of the president’s trade policy.

On Thursday, Trump and Fed Chair Jerome Powell held their first face-to-face meeting since the president started his second term. However, a Fed statement indicated the future path of monetary policy was not discussed and stressed that decisions would be made free of political considerations.

Trump slapped across-the-board 10% duties on all U.S. imports, part of an effort to even out a trading landscape in which the U.S. ran a record $140.5 billion deficit in March. In addition to the general tariffs, Trump launched selective reciprocal tariffs much higher than the 10% general charge.

Since then, though, Trump has backed off the more severe tariffs in favor of a 90-day negotiating period with the affected countries. Earlier this week, an international court struck down the tariffs, saying Trump exceeded his authority and didn’t prove that national security was threatened by the trade issues.

Then in the latest installment of the drama, an appeals court allowed a White House effort for a temporary stay of the order from the U.S. Court of International Trade.

Economists worry that tariffs could spark another round of inflation, though the historical record shows that their impact is often minimal.

At their policy meeting earlier this month, Fed officials also expressed worry about potential tariff inflation, particularly at a time when concerns are rising about the labor market. Higher prices and slower economic growth can yield stagflation, a phenomenon the U.S. hasn’t seen since the early 1980s.

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German inflation May 2025

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19 May 2025, Berlin: Apricots are sold at a greengrocer for 7.98 euros per kilogram. Grapes and papaya are also on offer.

Photo by Jens Kalaene/picture alliance via Getty Images

Germany’s annual inflation hit 2.1% in May approaching the European Central Bank’s 2% target but coming in slightly hotter than analyst estimates, preliminary data from statistics office Destatis showed Friday.

The print compares with a 2.2% reading in April and with a Reuters projection of 2%.

The print is harmonized across the euro zone for comparability.

So-called core inflation, which strips out more volatile food and energy prices, dipped slightly from April’s 2.8% to 2.9% in May. The closely watched services print meanwhile eased sharply, coming in at 3.4% compared to 3.9% in the previous month.

Energy prices fell markedly for the second month in a row, tumbling by 4.6% in May.

Germany’s consumer price index has been closing in on the European Central Bank’s 2% target over recent months, in a positive signal amid ongoing uncertainty about the economic outlook for Europe’s largest economy.

Domestic and global issues have mired expectations for Germany’s financial future.

One the one hand, U.S. President Donald Trump’s tariffs could damage economic growth, given Germany’s status as an export-reliant country, though the potential impact of such duties on inflation remains unclear. But frequent policy shifts and developments have been muddying the picture.

On the other hand, Germany’s newly minted government is starting to get to work and has made the economy a top priority. Questions linger about when and to what extent the new Berlin administration’s policy plans might be realized.

The ECB is set to make its next interest rate decision on June 5, with traders last pricing in an over 96% chance of a quarter point interest rate reduction, according to LSEG data. Back in April, the central bank had cut its deposit facility rate by 25 basis points to 2.25%.

This is a breaking news story, please check back for updates.

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