The Strategist

Shaken, not stirred: sticky inflation, tariff turmoil and Fed’s independence tested

Central bank chair is a tough job at the best of times. Jerome Powell’s Fed will be remembered as the Fed that left rates at record lows for too long when inflation raged, and subsequently tried to engineer a post-Covid soft landing (quite successfully for most of the normalisation phase). This effort was initially tempered by ultra-expansionary fiscal policy followed by disruptive and unprecedented tariff policy uncertainty and the prospect of fiscal interference into monetary policy making. 

Date
Author
Tina Jessop, Senior Economist, LGT Private Banking
Reading time
10 minutes

US Federal Reserve
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In short, the economic and fiscal policy backdrop was and still is exceptionally complex. Federal Reserve (Fed) Chair Powell understands that the Fed is navigating a precarious path: easing monetary policy prematurely could fail to tame inflation, while leaving rates restrictive for too long might harm US growth resilience. Despite the economic fog and policy noise, we expect the Fed to maintain a cool head and patience, as it monitors and assesses the feed through of current developments into economic data.  

Inflation stays uncomfortably high

January marked the 47th month of US Consumer Price Inflation (CPI) exceeding the Fed’s 2% target. The consumer price index (CPI) stubbornly defied expectations with an unexpected 0.5% month-over-month jump, topping the 0.3% rise expected by consensus. Year-over-year, prices increased by 3.0%, a tick more than December’s 2.9%. Core service price inflation at 4.4% remains stickier than anticipated despite its continued glacial sequential decline, and energy and core goods prices are no longer weighing on aggregate inflation numbers. While annual methodology adjustments and Californian wildfires have likely contributed, January inflation was clearly higher than the Fed had expected. 

This higher inflation reading coupled with solid US growth and a labour market that is "broadly in balance" with a low unemployment rate and robust job growth re-emphasises that the Fed is in "no hurry" to adjust its current policy stance. Jerome Powell reiterated during his semi-annual monetary policy testimonies before the Senate and the House that monetary policy conditions are now "considerably less restrictive" than they had been previously and are believed to be at an appropriate level to bring inflation closer to the 2% target. 

Tariffs are the known unknown that complicate Fed policy making

Rising tariffs and higher inflation present significant challenges for the Federal Reserve, particularly if tariff policies or tariff uncertainty impacts capital expenditure, hiring and consumption. As the tariff debacle is unfolding, inflation expectations for the next 12 to 24 months have surged, as evidenced in US breakeven inflation rates and the University of Michigan consumer survey. Interestingly, breakeven inflation expectations remained elevated even after tariffs on Mexico and Canada were postponed. In this context, Powell underlined that the policies from the new Trump administration will only flow into the Fed’s monetary policy considerations once they are enacted and the implications on growth and inflation become clearer. 

While there is still uncertainty regarding the scope and breadth of tariffs, we expect growth to suffer and inflation to rise. We have modeled a moderate upward shift in the effective US import tariff rate from 2-3% currently to ca. 7% into our US economic base case. This should translate into an additional 30-50 basis points increase in CPI inflation and mildly slower US real GDP growth. Sticky and rising inflation, along with further upside risks from immigration, regulatory and tax policies, justify high-for-longer monetary policy rates. We expect the Fed to remain on hold until late Q2 with two to three cuts by 2025 year-end.

A test to Fed independence, but concerns seem overdone

This high-for-longer stance may cause friction with the new US administration. President Trump has repeatedly advocated for lower rates. Powell, however, has repeatedly clarified that statements from fiscal policy makers have no impact on monetary policy considerations. He has also clearly stated that, by law, he cannot be removed from his position as Federal Reserve Chairman, nor would he consider resigning if requested by US President Donald Trump.

We believe market concerns regarding Fed independence are overdone. The president has no authority to influence central bank policy rates, and a change to the Fed’s mandate requires congressional approval. Nonetheless, President Trump will continue commenting on interest rates. However, as Treasury Secretary Scott Bessent clarified, the President is focused on longer dated interest rates. These determine government funding rates and thereby the government’s interest rate expense and the US deficit. They also have a more direct impact on the housing market and the cost of credit for the private sector.

Conclusion

The Fed's cautious approach, emphasising patience and data-driven decisions, reflects an understanding of the precarious path it treads and Powell's reassurances during his testimonies underscore the Fed's commitment to its inflation mandate.

As markets continue to grapple with policy implementations and their repercussions for monetary policy, volatility is likely to remain elevated. Ultimately, the Fed's ability to navigate these challenges with a steady hand will be crucial in steering the US economy through this turbulent period.

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