Tariffs and the Fed

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Fighting the last war?

As I’ve noted before, the Fed’s 2020 policy framework was designed to deal with the low-inflation-low-interest rate environment following the Great Financial Crisis. Three developments underpinned the new framework. First, years of sub-target inflation had started to “unanchor” inflation expectations to the downside. In macroeconomics jargon, the Phillips curve was shifting down. The Michigan measure of long-run inflation expectations had been averaging about 2.8%, but then drifted down by about a 0.5% in the five years leading up to the COVID shock. Second, the Phillips curve also seemed to be increasingly flat—low unemployment rates did not spark the expected inflation increase. Third, estimates of the real neutral funds rate had steadily slipped from 2% or higher to 0.5% or lower, suggesting the Fed had much less ammunition to battle a deflationary event.

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My artwork below illustrates the old and new Phillips curve. The new curve is flatter and lower. If correct, the only way to get inflation back to 2% is to run the economy hot, pushing the unemployment rate below estimates of the inflation-neutral “NAIRU.” Moreover, it the neutral nominal funds rate is just 2% (= 1.5% + 0.5%) then very low rates will be needed to bring the economy to boil.

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Putting it all together, the Fed was much more worried about chronic low inflation than high inflation. They worried that the US was following in the footsteps of Japan and Europe with very low inflation expectations and very little policy ammunition to deal with it.

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These concerns were the foundation of the 2020 Fed framework. The Fed formally adopted a 2% average inflation target, suggesting that periods of modestly low inflation should be offset by periods of modestly high inflation. Moreover, with a very flat and anchored Phillips curve, the Fed could react slowly to signs of overheating in the economy. Rather than hike in anticipation of inflation, they could wait until inflation was clearly moving above target and the labor market was at full employment. Any inflation overshoot would be small given the super benign “new” Phillips curve. This was the underpinning to the Fed’s delayed response to overheating in 2021-22.

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We are now seeing the flip side of the Fed’s 2020 framework: the Fed’s response to the high inflation of the last several years. Rather than try and offset some of that overshoot they have decided to reduce inflation back to target and in effect forgive the price level overshoot of the last several years. The chart shows the PCE price index along with a 2% path for inflation. As you can see the overshoot has now more than offset the undershoot even going all the way back to the business cycle peak of 2007. Over shorter time frames the overshoot is much bigger. The cumulative overshoot in the last ten years is 6% and since the COVID shock is 9%.

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That overshooting is not over yet and signs of inflation persistence have also triggered a dovish Fed response. As I’ve written a number of times, the Fed’s reaction to sticky inflation has not been to either raise the target or tighten policy, but to extend the time frame for hitting the target. We can see this in the latest median FOMC forecast for PCE inflation in comparison to the median a year ago. The Fed has moved out the expected time for hitting the target from the end of 2026 to the end of 2027, adding another 0.5% to the cumulative overshoot.

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Back to the future

The Fed is now starting its 5-year reassessment of its framework and it couldn’t come at a better time. The Fed faces a more normal environment than it did five years ago. As my regular readers know, I think some key macroeconomic relationships are reverting back to their pre-GFC (Great Financial Crisis) norms. Inflation expectations are no longer threatening to unanchor lower, but are threatening to unanchor higher. Getting inflation down is proving to be the main challenge, not getting it up. And there is growing evidence that the neutral nominal funds rate is not the 2% abnormal of the prior decade, but 4%-plus of prior to the GFC.

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This basic “normalization” assumption has a lot of important implications. First, it means the Fed is likely done cutting rates. If the neutral nominal rate is 4% or higher, the economy is doing fine and inflation is getting sticky high, why keep cutting? Indeed, as BofA’s Aditya Bhave argues, the next move could be a hike. Second, it means the economy is likely to remain resilient. Third, it means the main risk is for inflation to remain too high, not drop too low. Fourth, the rise in bond yields is not a fluke but is likely a move to the new-old normal. Strategist looking for “mean reversion” in interest rates are looking at the wrong mean.

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Tariff-man

Finally, the return to the pre-GFC normal means the Fed should focus on getting inflation down sooner rather than later. I think it would be a mistake for the Fed to look through upside shocks to inflation such as tariffs, even if the rise in inflation is small and temporary. The world has changed since 2020. With inflation expectations already starting to inch up, every year of above-target numbers adds to the risk of a significant unanchoring. According to CBO estimates a combination of 60% tariffs on China and 10% tariffs on everyone else would raise the price level by roughly 1% over two years. That additional 0.5% inflation could be the final straw. My guess is that the Fed understands this and will lean against the resulting inflation pressure. Hence, rate hikes are a real possibility.

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