Pick Your Poison: Higher Inflation or Slower Growth?

Key takeaways

• Tariffs will likely cause growth to slump and inflation to rise
• Fed officials will have to decide whether full employment or price stability is a higher priority
• We expect one to two Fed rate cuts by the end of the year

The Fed’s in a bind. Policy uncertainty is high. And tariffs are likely to hit the U.S. economy with a “stagflation-lite” impulse in coming quarters—weaker growth and higher prices. 

How will central bankers prioritize their full employment and price stability mandates in the rare circumstance where they’re losing ground on both goals at the same time? And how do they make policy decisions when the economic outlook is so unclear?

Stagflation complicates the calculus for a central bank. Weaker growth would warrant rate cuts. Higher prices argue in favor of hikes. Fed Chair Jerome Powell detailed the Fed’s approach to this scenario in a recent statement, described neatly in recent remarks. “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.”

Put differently, the bigger—and more persistent—miss is what will get emphasized, whether that’s sluggish growth or rising inflation. Enter version 2.0 of the “transitory” debate. Do tariffs cause a one-time increase in prices or do they generate more persistent inflation, affecting longer-term expectations? Those that believe the former will have a more dovish outlook and focus on protecting full employment—and vice versa. 

There are a range of views on this issue, including among Fed leadership.

In Fed circles there’s something known as the Brainard principle, which states that policy makers should act with caution when faced with uncertainty. This motivates some of the Fed’s wait-and-see approach to rates right now.

This uncertainty—coupled with a range of Fed participant views on how problematic tariff-driven inflation might be—has put the bank in a more reactive position. Why?

Simply put, the bank is unlikely to cut interest rates at coming meetings unless there is more convincing evidence that the business cycle is on the downswing. Any decline in labor market data could cause central bankers to pivot. We’ll look at initial jobless claims, nonfarm payrolls and Indeed’s daily data on new job postings for any signs of emerging weakness in the days to come.

With growth likely to continue slowing, we expect the Fed to cut rates at some point. In our view, one or two rate reductions in the second half of the year are likely.