The Federal Reserve is facing a heated internal debate on how to navigate the potential risks posed by tariffs. This disagreement threatens to end a period of relative unity among officials, as they diverge on whether potential cost increases warrant maintaining high interest rates.
In recent weeks, Federal Reserve Chairman Jerome Powell has hinted that the threshold for cutting interest rates may be slightly lower than it appeared in the spring when large tariff increases threatened to drive up prices and undermine the economy.
Trump's announcement in April of larger-than-expected tariff increases triggered concerns about a stagflation scenario (i.e., weakening growth and rising prices), disrupting the Fed's plans to resume rate cuts this year. In such an environment, Fed officials might need to see an economic slowdown before becoming confident that rising prices will be temporary.
Timiraos points out that two new dynamics have contributed to this potential shift. First, Trump has backed away from some of the most extreme tariff increases. Second, tariff-related consumer price increases have not yet materialized, although many officials and economists expect upward inflation pressure in the upcoming June and July data.
This represents a critical test of the debate over whether tariffs are inflationary and triggers internal disagreements over how to manage forecasting errors (regardless of direction). Robert Kaplan, former president of the Dallas Fed and current vice chairman of Goldman Sachs, says, "If the average tariff is closer to 10% to 15% rather than the much higher levels announced by the president, it will be easier for companies to absorb cost increases and avoid larger price increases.""
Kaplan believes that tariffs "may not be as inflationary as we feared" due to weak domestic demand and global excess capacity.
Powell's shift provides tactical flexibility for officials while studying inflation and employment data in the next three months. In his recent appearances, Powell has aligned himself with the position of the "vast majority" of Fed officials who expect rate cuts this year.
Powell describes the potential rate cut as a resumption of a process that was temporarily suspended only due to the risk of inflation caused by tariffs, suggesting that Powell believes current interest rates have been raised temporarily to protect against the risk of inflation caused by tariffs.
Timiraos believes that this development reflects an assessment that inflation risks may take longer to appear and are therefore less potent. If the Fed can maintain a less dramatic inflation growth forecast, Powell may open the door to a rate cut in late summer based on a weaker labor market or better inflation news.
Kaplan believes that a rate cut in July would be premature, but he says that if he were still at the Fed, "I would be psychologically prepared to conduct a serious review in September. This does not mean that I will take action in September, but I would like to be prepared."
In conclusion, the Federal Reserve faces complex challenges amid the uncertainty surrounding tariffs and their impact on inflation. Future decisions on interest rates will depend heavily on incoming economic data and a careful assessment of potential risks.
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