The Fed tilts at inflation windmills

Not so very long ago, Federal Reserve Chair Jerome Powell famously labeled the inflationary effects of the post-Covid global economy restarting as “transitory.” He reasoned that once the employment market recovered and the supply-demand imbalances equalized, the Fed had the tools to nudge the inflation rate back to the 2% target.

What he misjudged was that the Fed's own action of maintaining overnight rates at essentially zero for most of the years since the Global Financial Crisis had enabled borrowers to extend their debt maturities at very low rates. This served to somewhat insulate the economy against the impact of rising rates and mitigated the Fed’s ability to put the brakes on growth. Factor in the Biden administration and Congress’ lack of fiscal restraint, which provided ongoing stimulus through unbridled spending. Then add the reality of the mechanics of inflation calculations (perhaps overly) sensitive to a significant shock in shelter costs and the result has been an inflation genie that has been quite difficult to put back in the bottle.

With the inflation battle still not fully resolved, despite some steps toward less restrictive policy last year, Chair Powell has found himself faced with President Trump’s determination to implement a system of higher tariffs. In response, Powell reversed an earlier statement noting that some members of the board did consider potential future fiscal policy in the process of voting on the Fed funds rate. 

Powell’s rationale is reminiscent of Don Quixote, who saw things that were not there, most memorably charging a windmill he thought was a giant. The same thing is happening again. The Fed Chair’s belief in the inflationary potential of tariffs has led the central bank to suspend its easing cycle begun last fall. Instead of recognizing the inflationary potential of tariffs on imports for what it was, Chair Powell saw a giant.

Although tariffs introduce undeniable uncertainty, we think they are better considered a growth-impeding tax rather than a stimulant to an inflationary spiral. Even should the tariffs pass entirely through to consumers—extremely unlikely—the fact that necessity goods will absorb a larger share of finite household wallets likely means reduced demand for other items and services. That’s hardly the formula for an increase in economy-wide price levels. 

Further, with inflation quantified as the change in prices from one year to the next, a hike in effective tariffs from something like 3% to 18% today is probably not going to be followed by another 15% increase next year. We think tariffs’ hit to inflation will in fact be "transitory" and the rate of change will fade. 

We look forward to the growth-enhancing effects of deregulation and the personal tax cuts and corporate investment incentives from the “One Big Beautiful Bill.” In the meantime, the economy is challenged by the burden of Powell’s restrictive policy. This burden is especially evident in the housing market where activity is stifled by a lack of affordability largely due to the elevated level of mortgage rates. 

In other words, there are consequences to the Fed’s resistance to ending its fight against inflation, as the most recent jobs report made clear.  

Here's hoping Powell soon realizes that he is tilting at windmills, before the Fed’s misdirected efforts against apparitions create problems of their own.