The Fed sees slower growth and higher prices

The Federal Reserve cut its forecast for 2025 GDP growth to 1.7 per cent and raised its forecast for core personal consumption expenditures (PCE) inflation to 2.8 per cent. The updated Summary of Economic Projections from the Federal Open Market Committee disappointed anyone still hoping for a smooth landing. Slower growth and faster inflation at the same time is the familiar mark of stagflation.

The shift from December's projections was large for a single quarter. Three months ago the committee expected growth of 2.1 per cent this year and core inflation of 2.5 per cent. It also nudged up its forecast for unemployment. The policy rate stayed in its range of 4.25 to 4.5 per cent, where it has been since December, and the median official still pencils in two quarter-point cuts before the end of the year.

What changed since December

The explanation is trade policy. Since January the administration has imposed tariffs on Chinese goods, on steel and aluminium, and, with exemptions that change from week to week, on imports from Canada and Mexico. Broader "reciprocal" tariffs are promised for early April. Businesses have responded by delaying investment decisions, and consumers by telling pollsters that they expect higher prices. Long-run inflation expectations in the University of Michigan's survey have risen to their highest reading since the early 1990s.

The committee also slowed the shrinking of its balance sheet, cutting the monthly cap on Treasury runoff from $25 billion to $5 billion from April. Christopher Waller, a governor, dissented from that decision, though he supported holding rates steady. The change is technical, aimed at keeping money markets calm, but it removes one source of upward pressure on long-term yields at a moment when the committee is wary of doing anything that looks like tightening.

Either choice hurts

When growth slows and prices speed up, the central bank's usual responses stop working. Cutting rates to help a softening labour market risks locking in inflation expectations above target. Keeping rates high to stamp out the remaining price pressure could turn a mild slowdown into a nasty contraction in which households and firms cut debt.

The Fed's dual mandate makes the trade-off explicit. Congress asks it to pursue both maximum employment and stable prices, and in normal downturns the two point the same way: weaker demand lowers inflation and justifies cuts. A tariff shock splits them. The committee's own projections now show inflation moving further from its 2 per cent target while unemployment edges higher, which leaves each official to decide which miss matters more.

The 1970s and 2021

The historical warning on both sides is well known. In the 1970s the Fed under Arthur Burns treated successive oil and food price shocks as temporary, eased too readily, and allowed inflation expectations to drift upwards until Paul Volcker had to raise rates to punishing levels and accept a deep recession to restore credibility. More recently, the Fed described the post-pandemic surge in prices in 2021 as transitory and was then forced into the fastest tightening in four decades.

That second episode weighs heavily on the current committee. Having been wrong once about a supply shock, officials are reluctant to assume that tariff-driven price rises will fade on their own, even though a one-off increase in import prices should in theory raise the price level once rather than the inflation rate permanently. The theory holds only if wage demands and expectations stay anchored, which is precisely what the Michigan survey calls into question.

Costs the Fed cannot fix

Chairman Powell and his colleagues are dealing with cost shocks from outside the economy. Demand is not running too hot. Tariffs and the rearrangement of supply chains are pushing up unit costs across the board, and interest rates cannot remove that pressure without pushing demand into real trouble.

The channels are direct. An importer that pays a tariff at the border either absorbs it in a thinner margin or passes it on to a retailer, who passes it on to shoppers. Domestic producers that compete with imports gain room to raise their own prices. Companies that source parts from abroad face higher input costs and less certainty about where to build. Higher interest rates can suppress spending, but they do nothing to lower the price of a tariffed component.

Who pays for waiting

A Fed that holds rates steady spreads the cost unevenly. Savers continue to earn money-market yields above 4 per cent, which is a rare benefit in a slowdown. Borrowers with floating-rate debt, from small businesses on bank credit lines to households carrying credit-card balances, get no relief. Housing stays frozen because mortgage rates track long-term Treasury yields, which have little reason to fall while inflation forecasts are rising. Equity investors, who had been counting on cuts to support valuations, have already marked down the most expensive shares.

The case against the stagflation reading deserves a hearing. Unemployment remains low by historical standards, household balance sheets are in decent shape, and a forecast of 1.7 per cent growth describes a slowdown rather than a recession. If the tariffs are negotiated away, both halves of the problem could shrink quickly. The committee, too, still expects to cut rates this year, which hardly signals alarm.

What would move the Fed

The data that will settle the argument are the monthly payroll and inflation reports, the next readings of household inflation expectations and the details of the April tariff package. A sharp rise in unemployment claims would push the committee towards cuts. Evidence that companies are passing on tariffs in full, or that workers are demanding compensating pay rises, would keep it on hold. The committee next meets in early May.

The new forecasts amount to an admission that rate policy cannot solve this problem, and the Fed will probably sit on its hands for months, accepting somewhat higher inflation and somewhat weaker growth rather than choosing between them. Borrowers should not expect relief before the summer at the earliest, and if the April tariffs are as broad as promised, the two cuts in the committee's median forecast look more like a hope than a plan.