Powell Wants the Fed to Look Through Tariffs but Will Have to See if the Data Lets Them
- “I don’t know anyone who is confident in their forecast,” Chair Powell capturing the zeitgeist well.
- Taken together today, my odds in the Fed’s willingness to ease in the event of an appreciable tariff shock have gone up. But they may not be able to do preemptively and probably require actual, if early, weakness in the labor market and growth data to justify that move, even if they assess that the inflation effect is transitory.
- There is a large, embedded bet by the median participant that the tariff shock will not impact medium-term inflation, whether through second round knock on effects or the more ambiguous but broader inflation expectations channel.
- By being so benign in his description of recent inflation and fairly skeptical of the potential second round and less-anchored inflation expectations series, Chair Powell left open to the possibility of future hawkish risks should the inflation data not cooperate.
- Those who shifted to 0 or 1 cuts for the year seem to clearly be less confident in this assumption and are likely of the view that at least slightly less supportive policy is necessary to restrain second round and expectations effects. I expect we will hear a lot from them once the blackout period is over.
- The bull steepening rally in markets seems the correct result. Powell was mildly dovish in terms of his assessments and embedded reaction function but the medium-term balance between dovishness, inflation, and recession risks is less clear (5y5y swaps were down ~3bps in response to the meeting while 2y were down ~10bps).
For my quick thoughts on the SEP and dot plot see this piece.
The forecasts and Powell suggest that they (the median participant) will be ok easing 2x this year with core PCE running around or above 2.8%. How might that look in reality if we take it seriously in light of Powell’s comments and the SEP today (I would note that Jason Furman earlier today said he is quite skeptical of this joint outcome)? The tariffs likely need to be fairly one-and-done rather than rolling; analytical and compositional assessments of the realized inflation data show a large impact from imported goods; longer-term inflation expectations remain low enough the Fed can say they are well anchored (precise numerical definitions seem pointless given the Fed’s inconsistent treatment of the subject over the years); y/y core continues to have a 2-handle; we see a few months of more sanguine data after the direct tariff related impacts; and the growth and labor market data is inline with expectations or worse. Barring a nothingburger tariff announcement on April 2nd, this seems to push the earliest cut date out farther to the fall unless one assumes the labor market rapid loses momentum in the near-term. Labor market retightening sufficient to pull down the medium-term unemployment rate forecasts to 4.1% or below likely makes the above a moot point; there would be no incentive to ease then beyond a weakly held prior on the level of r*.
One clear takeaway from the press conference is there remains a labor market weakness conditionality which would lead to easier policy, seemingly even if there is lack of further progress on inflation. There appears to have been enough progress made on inflation, I guess still having a 2-handle counts in extremis, that the risks of an apparent (not preemptive) weakening in the labor market would outweigh the current inflationary miss which would at least mildly continue for some time going forward.
Before tariffs started to drive some of the recent price action it was clear in Powell’s view that “we were getting closer and closer to price stability” until quite recently, and that while “further progress [towards the 2% target] may be delayed” it has not been fully prevented over the forecast horizon. This stands in notable contrast to Powell’s January press conference where he was noting that “at the end of the day, it, it comes down to 12-month inflation, because that takes out the seasonality issues that may exist. And, you know, we’re, we’re just going to need to see that. We think that—we think we see the pathway for that to happen.”
Chair Powell noted that “it is going to be difficult to have a precise estimate” of what part of inflation is being driven by tariffs. It is “too soon to say” if we should look through the inflation shock that is presumptively “transitory”; whether or not that ends up being the case will depend on the quick pass-through of the shocks and that longer-term inflation expectations remain “well anchored.” In framing this view on how the tariffs will be transitory he went on to note that “I think that [transitory] is kind of the base case.” This transitory view allows for further easing despite the inflation forecast upgrades.
The reason for this shift seems to come down to the above-mentioned view that inflation’s medium-term dynamics will remain well anchored and the Taylor Rule-like balance between the inflation and unemployment rate forecast shifts (which I noted in my writeup on the SEP and dot plot above). Powell’s discussion on the baseline approach to looking through the inflationary shocks of tariffs, given the tension between the Fed’s two goals that a supply shock like tariffs creates, was basically a rearticulation of optimal control style policy making; “what we’ll do is look at how far each of those two measures is from its goal and then we’ll ask how long we think it might take to get back to the goal for each of them… our tools work in one direction. We’re either tightening or loosening. So it’s a very challenging situation.” But Powell was quick to note that the forecast doesn’t anticipate large scale departures from the FOMC’s goals so that prospective balancing act in the extremes is currently a theoretical exercise.
As has come up again and again in recent weeks, the soft data appears much worse than the hard data. Powell noted that Fed intelligence gathering and the more public surveys show that “we do understand that sentiment has fallen but economic activity has not yet, so we are watching carefully.” Despite the current sentiment hit, “all told it’s too soon to be seeing significant effects [of tariffs] on the economic data.”
In describing the labor market Powell continued to use fairly optimistic language, as most participants have been in recent months, but he did mention the inherent brittleness of a labor market where “the hiring rate is quite low but so is the layoff rate… the question is which way does that break [in the event of any further shocks].”
Again, Powell seemed to note that the 5y strategy review will be wrapped up by late summer, highlighting the likely focus on the Jackson Hole conference in August.
