Years passed before the Fed managed to curb inflation. However, Trump's trade war disrupted the economy's progress.
A New Threat on the Horizon: Stagflation?
After snatching a surprising victory over inflation last year, the Federal Reserve is now grappling with a potential reversal. The looming threat of a global trade war under President Donald Trump's second term could undo the historical success, casting a dark cloud over the economy.
Since Trump's inauguration in January, significant changes in trade policy, immigration, and federal workforce have left consumers, businesses, and investors on edge. Consequently, major stock indexes plummeted from record highs to correction territory, and consumer sentiment plummeted to its lowest level since November 2022.
Central bankers face the daunting task of determining the economy's response to Trump's "shock therapy." Analysts have already predicted higher inflation and weaker growth this year, eerily resembling the dreaded 70s relic—stagflation.
When the Fed's March meeting concludes on Wednesday, interest rates are expected to remain steady. However, Fed Chair Jerome Powell will likely reaffirm the economy's strong foundation, yet admit the economy is on a path toward stagflation, say economists.
Powell's mission is to reassure an anxious nation about the Fed's strategy to tackle the impending stagflationary threat. With various surveys revealing increased negative perceptions of prices, it's a delicate balancing act.
"It's tough to predict how these contradictory forces will eventually balance out. The Fed is currently assessing the situation and stands ready to make necessary adjustments if needed," says Tom Bruce, macro investment strategist at Tanglewood Total Wealth Management.
Stalemated Inflation Fight
Before Trump took office, signs of a slowdown in inflation were already emerging, which prompted the Fed to cease cutting interest rates in January. The Fed's solution? A wait-and-see approach until inflation subsides again.
In January, the decision was simple due to a robust economy with low unemployment and steady growth. However, Fed officials might not have that luxury for long.
Trump's tariffs can not only escalate prices but also hamper growth. Global economists at the Organisation for Economic Co-operation and Development warned on Monday that new tariffs will slow economic activity and, in turn, affect regular tax revenues.
Trump has promised his administration will match foreign countries' tariffs on U.S. goods starting April 2. Initially imposed tariffs, such as on metals and Chinese goods, were met with swift retaliation.
The protracted trade war comes at a time when domestic consumers might be reining in spending: Retail sales, accounting for a third of overall spending, were much weaker than anticipated in February. Consumer spending slumped in January during unusually harsh cold weather, which is expected to hinders economic growth in the first quarter of the year.
"We're grappling with inflationary forces, but we also expect a decline in consumer spending due to the cooling job market," explains Sarah House, senior economist at Wells Fargo.
Rising Inflation Expectations
The American public isn't just on edge but shows signs of losing faith in a return to normal inflation levels. Fed officials focus on public sentiment because it can become self-fulfilling. If people expect prices to escalate in the long term, they can adjust their spending accordingly, making it difficult for the Fed to maintain its role.
In March, Americans' expectations for inflation in the upcoming year shot up to 4.9%, the highest since November 2022. Additionally, long-term expectations for inflation surged to 3.9%, marking the largest month-over-month increase since 1993.
Several Fed officials have expressed concern over escalating inflation expectations, indicating they might raise interest rates to keep expectations in check, even if unemployment rises.
"Higher tariffs and immigration policies, often discussed, are believed to raise prices and cool aggregate demand, potentially softening employment. From the perspective of monetary policy, it could be appropriate to disregard or look through an increase in the price level if the impact on inflation is short-lived and limited," said St. Louis Fed President Alberto Musalem last month in New York.
"However, a different monetary policy response could be necessary if inflation persists or long-term inflation expectations rise," he added.
The Fed is scheduled to announce its latest rate decision at 2 p.m. ET on Wednesday, followed by a press conference with Chair Powell at 2:30 p.m. ET.
- The potential for stagflation is causing businesses and investors to reassess their strategies, as Federal Reserve Chair Jerome Powell acknowledges the economic path toward this condition.
- In an attempt to prevent a stagflationary threat, economists suggest the Federal Reserve may need to reconfigure its monetary policy to address escalating inflation and weaker growth.
- With the Federal Reserve acknowledging the possibility of stagflation and economists suggesting a reevaluation of monetary policy, the nation's business and economic leaders grapple with how to adapt to the unfolding economic landscape.
