Stephen Miller
As the Trump Administration assumed office, markets not only had priced ‘goldilocks’ but looked to be embracing a euphoric scenario. Inflation was in retreat; the Fed was cutting rates; bond yields were set to decline, all of which led to ebullient equity markets.
To many observers, it appeared that Jerome Powell’s Fed had nailed something that had eluded a number of his predecessors: he had stuck the soft landing…almost!
The Fed’s Federal Open Market Committee (FOMC) meeting overnight was therefore keenly awaited, not so much in anticipation of any rate adjustment (there was none) but more so to ascertain Fed views on the evolving economic outlook.
The Fed’s policy rate “dot plot” maintained the same median expectation as in December for just two 25 basis point (bp) policy rate cuts for 2025.
Perhaps the most striking element of the Fed’s decision was the incremental swing toward a ‘stagflation-lite’ scenario implied by its economic projections. They revealed that the Fed had revised downwards its growth forecasts for 2025 (from 2.1 per cent to 1.7 per cent) and revised up its inflation forecast (core private consumption expenditures (PCE) price index) to 2.8 per cent from 2.5 per cent, reflecting potential tariff impacts. The unemployment rate was revised up marginally to 4.4 per cent from 4.3 per cent.
In his press conference Chairman Powell seemed to imply that the tariff consequence was (…ahem!) “transitory”. That reflects a narrative that has been fomented by Treasury Secretary Scott Bessent. It may have some kernel of accuracy, but only a kernel.
There is much that can go wrong.
On the inflation side, and as Chairman Powell stressed during his press conference, the degree of persistence in inflation will depend on whether “transitory” price increases due to tariffs are reflected in inflation expectations. Powell appeared to be optimistic on that front.
But as we learnt during the post-pandemic period “transitory” elements can persist for longer than policymakers assume and there are key reasons for thinking that the dangers of persistence are currently higher than they have been for some time.
For one thing the recent post-pandemic experience will heighten the risk that inflation expectations reman elevated in the wake of price increases motivated by tariffs.
For another, the structural currents on inflation are now running in an adverse direction as price pressures are reinforced by the retreat of globalisation of goods markets as governments everywhere (including successive US Administrations) introduce protectionist measures (tariffs) under the specious guise of “industrial policy” and “national champions” or “national security”.
Immigration restrictions and the exit of baby-boomers from the workforce will also add to inflation pressures via higher wage growth, absent any offsetting productivity improvements.
When Donald Trump became US President for a second time the prospects of a US recession in 2025 were small – but not non-trivial.
Less than two months into his term that risk seems to me close to even-money.
And where it come to pass, the US authorities are less well-equipped to deal with a recession than they have been for some time.
To get some insight into how quickly things have turned, real gross domestic product (GDP) through 2023 and 2024 averaged 2.9 per cent and ranged between 1.6 per cent and 4.4 per cent. The current Atlanta Fed GDPNow estimate, for current quarter GDP, is -1.8 per cent. It won’t take that much to go from there to the popular definition of a recession (two successive negative quarters of GDP growth).
In the past quiescent inflation has allowed the Fed to respond with alacrity to downdrafts in growth.
In the current environment, however, “sticky” inflation has robbed the Fed of the flexibility to quickly cut rates, a flexibility that it enjoyed in the two decades or more leading up to the pandemic.
And with a budget deficit approaching 7 per cent of GDP, fiscal policy is close to maxed out.
Financial markets appeared to be buoyed by Powell’s disposition to favour the “transitory” narrative on tariffs as bond yields declined and equity markets rallied.
Markets appear to believe that Powell and the Fed can stick the soft landing.
I fear that the Administration’s meddling with the landing gear may make that task more difficult.
