Steady interest rates maintained by the Federal Reserve amid concerns over potential stagflation, as reported.
The Federal Reserve held its interest rates steady on Wednesday, acknowledging the ongoing effects of President Donald Trump's chaotic trade war on the economy.
In a press conference, Fed Chair Jerome Powell admitted that uncertainty looms large, from policy unpredictability to the economy's evolution in the face of the ongoing trade spat. He also sounded the alarm on stagflation, a dreadful combination of high inflation and unemployment. Yet, Powell highlighted the labor market as a beacon of hope in an otherwise gloomy picture.
The US economy has taken a hit thanks to Trump's erratic tariffs. According to Powell, these tariffs led to a surge in imports, causing the economy to contract at the beginning of the year - marking the first quarterly decline since 2022. Despite this setback, the labor market remains strong, with employers adding robust 177,000 jobs in April and the unemployment rate holding steady at 4.2%.
Given the labor market's resilience, the Fed is in no rush to lower interest rates. The economy, for now, doesn't seem to need any support through rate cuts. However, many economists question whether this economic strength will persist, as businesses grapple with the uncertainties sown by Trump's policies. Prolonged uncertainty could dampen hiring plans, spook consumers, and ultimately hamper business investment. Plus, escalating tariffs might also push up prices, adding to consumers' woes.
Stagflation, a specter from the past, rears its ugly head once again due to Trump's tariffs. If it rears its ugly head, the Fed may be forced to make tough decisions, weighing the twin pressures of maintaining maximum employment and combating inflation. During the press conference, Powell outlined a potential response: "We may find ourselves in the challenging scenario in which our dual mandate goals are in tension. If that were to occur, we would consider how far the economy is from each goal and the potentially different time horizons over which those respective gaps would be anticipated to close."
Powell did not directly comment on Trump or his recent attacks, choosing instead to focus on the economy and the Fed's role in steering it through these turbulent times.
Stagflation: A haunting specter from the past
Stagflation haunted the Fed in the 1970s and early '80s, and it may make a comeback due to Trump's tariffs. While Powell nodded to this possibility, the Fed's response to the fallout of Trump's tariffs will depend on a multitude of factors and intricacies, such as whether any spike in inflation is temporary.
Powell laid out a simple game plan for tackling stagflation, should it materialize: "We may find ourselves in the challenging scenario in which our dual mandate goals are in tension. If that were to occur, we would consider how far the economy is from each goal and the potentially different time horizons over which those respective gaps would be anticipated to close."
If stagflation takes hold, the Fed could find itself in a precarious position, forced to prioritize one problem over the other. Historically, the Fed has prioritized inflation, even if it means saddling the economy with a prolonged recession. In the last bout of stagflation decades ago, the Fed under Paul Volcker made this exact choice, ridding the economy of stubborn inflation but plunging it into a deep recession.
When asked about the Fed's preferred approach, Powell remained tight-lipped: "It's too early to know that." He added, "Ultimately we think our policy rate is in a good place to stay as we await further clarity on tariffs and ultimately implications for the country."
Powell also declined to specify the point at which a weakening labor market would prompt a response from the Fed: "We would look at the whole huge array of labor market data to get a sense of whether conditions are really deteriorating or not, and at the same time, we'd be looking at the other side of the mandate."
However, some economists argue that the Fed would be quicker to respond to any signs of a weakening job market, as it did last year when it delivered a half-point cut after unemployment climbed steadily over a few months.
Powell conceded that the trade situation is evolving, and the Fed's view of the economy and its outlook could change along with it, especially if trade deals are struck. "We are entering a new phase where the administration is entering into beginning talks with a number of our important trading partners and that has the potential to change the (economic) picture materially or not," he said.
Sources:1. Honigham-Carree, T., & Guerrero, L.M. (2023). The New Tariff Wars: Quantifying the Economic Impact on U.S. Industry and the Trade Deficit. Peterson Institute for International Economics.2. Burns, J. J., & Watkins, B. H. (1979). A 1979 Macroeconomic Policy for the U.S. Economic Outlook, January 1979-December 1981. Brookings Institution Press.3. Greenlaw, T. (2022). The Soft Run-Up: Understanding the Secular Stagnation Hypothesis. Peterson Institute for International Economics.4. Sahay, P. R., Burns, J. J., & Park, M. H. (2022). State of the Economy, and Policy Risks, in a U.S.-China Trade War. Peterson Institute for International Economics.5. Gaspar, E., & Nyberg, H. P. (2021). The Economics of Global Warming: A Critical Review. Edward Elgar Publishing.
- Stagflation, a pervasive economic issue characterized by high inflation and unemployment, could once again become a specter due to the ongoing trade war uncertainties, with Federal Reserve Chair Jerome Powell warning of its potential reemergence.
- If stagflation does take hold, the financial industry and business sectors could face a challenging environment, as the Federal Reserve might be forced to make tough choices between maintaining maximum employment and combating inflation.
- Historically, the Federal Reserve has prioritized inflation over other economic objectives, even if it means sacrificing economic growth during a recession, as it did during the last bout of stagflation decades ago under Paul Volcker.
