The Federal Reserve Faces a Challenging Economic Landscape

A Sharply Changing Economic Outlook

When Federal Reserve officials gathered in late January, the economic outlook appeared relatively stable. The job market was robust, with solid hiring trends, and the economy had grown at a respectable pace in the final quarter of the previous year. Inflation, while still a concern, had eased significantly from its peak over two years earlier. However, the economic landscape has shifted dramatically over the past seven weeks. As the Fed prepares for its meeting this week, policymakers are now confronted with a more complex and uncertain environment. Inflation, while slightly improved, remains elevated, and the threat of rising tariffs could push prices even higher. Simultaneously, ongoing tariff threats, along with cuts in government spending and jobs, have eroded consumer and business confidence. These factors could weaken the economy and potentially drive up unemployment. The combination of high inflation and a sluggish economy is a worrying scenario known as "stagflation," a term that strikes fear into the hearts of central bankers.

The Challenge of Stagflation

Stagflation is a rare and challenging phenomenon where inflation remains high even as economic growth stalls and unemployment rises. This situation creates a dilemma for the Federal Reserve. Typically, the Fed would raise or maintain high interest rates to combat inflation. However, if unemployment begins to rise, the Fed would usually cut rates to lower borrowing costs and stimulate economic growth. Balancing these competing objectives is no easy task. While it is not yet clear if the U.S. economy is heading into stagflation, the Fed, like businesses and consumers, is grappling with significant uncertainty about the economic outlook. Even a mild form of stagflation, where unemployment ticks up from its current low of 4.1%, while inflation stays above the Fed’s 2% target, would pose significant challenges for policymakers.

The Fed’s Likely Course of Action

Given the current economic conditions, Fed officials are expected to keep their key interest rate unchanged during this week’s meeting. Once the meeting concludes on Wednesday, they will release their latest quarterly economic projections, which are likely to indicate that policymakers expect to cut rates twice this year. This aligns with their projections from December. The Fed implemented three rate cuts last year and signaled in January that it was largely on pause until the economic outlook became clearer. Wall Street investors, however, are betting on three rate reductions this year, in June, September, and December, reflecting their concerns about an economic slowdown forcing more aggressive cuts.

Rising Inflation Expectations: A Cause for Concern

One development that is likely to unsettle Fed officials is the sharp increase in inflation expectations reported in the University of Michigan’s consumer sentiment survey earlier this month. The survey showed the largest jump in long-term inflation expectations since 1993. Such expectations are crucial because they can become self-fulfilling. If businesses and consumers anticipate higher costs, they may take actions that drive up inflation, such as demanding higher wages or raising prices to offset increased labor costs. While some economists caution that the University of Michigan’s survey is preliminary and based on a smaller sample size of around 400 responses, the final version, which will include about 800 responses, is eagerly awaited. Meanwhile, financial market measures of inflation expectations, based on bond prices, have actually declined in recent weeks.

Mixed Inflation Readings and Policy Implications

The latest inflation readings have been mixed. The consumer price index dropped last week for the first time in five months, falling to 2.8% from 3%, which is an encouraging sign. However, the Fed’s preferred price gauge, which is set to be released later this month, is expected to remain unchanged. The jump in inflation expectations is a problem for the Fed because policymakers, including Chairman Jerome Powell, have indicated a willingness to allow inflation to gradually return to the 2% target by 2027, given that expectations have generally been low. If other measures of inflation expectations begin to rise, the Fed could face increasing pressure to bring inflation down more quickly.

The Role of Tariffs in the Economic Equation

The imposition of tariffs by President Donald Trump in 2018 and 2019 had a limited impact on overall inflation, largely because the tariffs were not as broad as the current proposals and included loopholes. However, after enduring a painful inflationary episode, Americans are likely to be more sensitive to rising prices now. Powell addressed these concerns earlier this month, stating that tariffs could have a one-time impact on prices without triggering ongoing inflation. However, he conceded that this could change "if it turns into a series" of tariff hikes or "if the increases are larger." Powell emphasized that what really matters is what happens with long-term inflation expectations. A week after his remarks, those expectations surged higher in the University of Michigan survey.