Key Takeaways
- The Federal Reserve remains steadfast in its data-dependent approach, creating a direct conflict with political calls for immediate interest rate reductions ahead of potential tariff implementations.
- While headline import prices have shown recent softness, the historical precedent from 2018-2019 suggests that broad tariffs have a tangible, though complex and non-linear, impact on consumer inflation and business investment.
- Market pricing reflects significant ambiguity. While Fed Funds Futures show conviction building for a cut later in the year, prediction markets indicate a near 50/50 split for a September move, highlighting a divergence between economic fundamentals and political event risk.
- Investors face a dual threat: a hawkish Fed holding rates higher for longer due to persistent inflation, or a dovish pivot forced by a tariff-induced economic slowdown, creating a difficult environment for asset allocation.
The Federal Reserve is caught in an unenviable position, wedged between its mandate for price stability and intensifying political pressure to lower interest rates. This tension has been brought into sharp relief by calls from former President Trump to cut rates immediately, arguing that tariffs have not been inflationary and that falling import prices justify a more accommodative stance. However, Federal Reserve Chair Jerome Powell has maintained that the uncertainty surrounding future trade policy is a key reason for the central bank’s cautious posture, complicating an already difficult task of navigating the final mile of inflation reduction. [1][2]
The Fed’s Data-Dependent Standstill
The Federal Open Market Committee (FOMC) has been explicit: its decisions will be guided by the totality of the data, with a specific need for “greater confidence that inflation is moving sustainably toward 2 percent” before considering a rate reduction. [3] Recent economic data presents a mixed, and arguably unhelpful, picture for those advocating an imminent cut. While there have been some encouraging signs in inflation reports, core services inflation remains sticky, and the labour market continues to show resilience.
Chair Powell has directly linked the policy path to trade uncertainty, noting that the prospect of significant new tariffs could have material economic consequences that the Fed must be prepared for. This is not political commentary, but a pragmatic assessment of risk management. A sudden change in trade policy represents an exogenous shock that could simultaneously slow growth and increase prices, a stagflationary combination that poses the most difficult challenge for monetary policy.
| Economic Indicator | Latest Reading | Implication for Fed Policy |
|---|---|---|
| Core PCE Inflation (YoY) | 2.8% | Remains stubbornly above the 2% target, justifying continued caution. |
| Headline CPI Inflation (YoY) | 3.3% | Moving in the right direction but still elevated. |
| US Import Price Index (MoM) | -0.4% | Supports the argument of disinflation from foreign goods, but tariffs would reverse this trend. |
| Unemployment Rate | 4.0% | A still-tight labour market that suggests underlying economic strength. |
Source: Bureau of Economic Analysis, Bureau of Labor Statistics. Data as of most recent releases.
Revisiting the Tariff and Inflation Nexus
The assertion that tariffs are not inflationary warrants closer inspection. While it is true that headline import prices have recently declined, this is largely a function of global supply chain normalisation and softening demand. It does not provide a reliable guide to what would happen following the imposition of broad new tariffs, which act as a direct tax on imported goods.
Analysis of the 2018-2019 trade dispute shows that the costs were almost entirely passed through to US importers and, ultimately, consumers. [4] The nuance is that this did not translate into a dramatic spike in headline CPI at the time, partly because the affected goods constituted a relatively small portion of the overall consumer basket and other global disinflationary forces were at play. However, a repeat of such policy in today’s more fragile inflationary environment could produce a very different outcome. The second order effects, such as retaliatory measures and the chilling effect on business investment due to policy uncertainty, are arguably more damaging than the direct price impact.
Reading the Market’s Ambiguous Signals
Financial markets are struggling to price these conflicting inputs, leading to a notable divergence in expectations. The institutional interest rate futures market, which reflects professional positioning and economic modelling, has steadily increased the probability of a rate cut by the end of the year, but assigns a lower probability to a September move. In contrast, prediction markets like Polymarket, which can sometimes capture broader political sentiment, show odds hovering around 50% for a September cut, indicating a belief that political pressure could force the Fed’s hand. [5]
This gap between the calculated, data-driven view and the more event-driven speculative view encapsulates the current dilemma. Is this a normal economic cycle, or is it one about to be disrupted by a political catalyst? The Fed is preparing for the former, while a segment of the market is betting on the latter.
Conclusion: A Collision Course for Policy
For investors and portfolio managers, the path forward requires a focus on resilience. The binary outcome is stark: either the Fed holds firm, keeping rates elevated and potentially weighing on risk assets, or it is forced to react to a policy-induced shock. This suggests that portfolio construction should favour companies with strong domestic revenue streams, robust balance sheets, and pricing power that can withstand either inflationary pressures or a growth slowdown.
As a final, speculative hypothesis: the market may be mispricing the nature of the “policy error” risk. The consensus fear is that the Fed cuts too early, reigniting inflation, or cuts too late, causing a recession. The true, underappreciated risk is that the Fed is forced into a reactive stance by a tariff shock, having to navigate a stagflationary environment where its tools are least effective. In such a scenario, the Fed’s credibility, its most valuable asset, would be severely tested, with unpredictable consequences for all asset classes.
References
[1] Jacobs, J. & Puzzanghera, J. (2024, July 1). Powell Says Trump’s Tariff Threat Complicates Fed Rate-Cut Path. Bloomberg. Retrieved from https://www.bloomberg.com/news/articles/2024-07-01/powell-says-trump-s-tariff-threat-complicates-fed-rate-cut-path
[2] Guida, V. (2024, July 1). Powell blames Trump’s tariff threats for preventing interest rate cuts. Politico. Retrieved from https://www.politico.com/news/2024/07/01/powell-trump-tariffs-fed-rate-cuts-00165842
[3] Federal Reserve. (2024, June 12). Federal Reserve issues FOMC statement. Board of Governors of the Federal Reserve System. Retrieved from https://www.federalreserve.gov/newsevents/pressreleases/monetary20240612a.htm
[4] Amiti, M., Redding, S. J., & Weinstein, D. E. (2019). The Impact of the 2018 Trade War on U.S. Prices and Welfare. CEPR Discussion Paper No. 13564. Retrieved from https://cepr.org/publications/dp13564
[5] Polymarket. (2024). Will the Fed cut rates by the end of the September 2024 meeting?. Retrieved from https://polymarket.com/event/will-the-fed-cut-rates-by-the-end-of-the-september-2024-meeting
[6] StockSavvyShay. (2024, July 8). [Post on Trump urging rate cuts and Polymarket odds for September]. Retrieved from https://x.com/StockSavvyShay/status/1810736250199457792
