BY Jamie McGeever
ORLANDO, Florida- Focus on the “stag”. Ride out the “flation”. That may be the Federal Reserve’s optimal plan for handling the new wave of tariffs coming from the Trump administration.
With details of US President Donald Trump’s sweeping tariffs now emerging, all eyes will soon turn to the Fed’s and other central banks’ response to the president’s “liberation day” duties that could leave them in quite a bind.
It’s generally agreed that tariffs are damaging to growth and inflationary, initially at least. So how should central bankers react? Do they cut interest rates to prop up a stagnating economy or raise them to cool fiery price pressures?
According to a Minneapolis Fed working paper published last month, the answer is clearly the former. The authors find that the “optimal” policy response to tariffs is not just to look through the inflationary impact and keep rates steady, but to go even further and ease policy.
“The optimal monetary response is to stimulate the economy, raising aggregate income and boosting demand for imported goods,” wrote Minneapolis Fed economist Javier Bianchi and University of Wisconsin-Madison assistant professor Louphou Coulibaly.
The optimal response, they argue, “is expansionary, letting inflation rise above and beyond the direct effects of tariffs. This result holds regardless of whether tariffs apply to consumption goods or intermediate inputs, whether the shock is temporary or permanent.”
Adverse effects
This all runs counter to the commonly held belief that pouring fuel on an inflationary fire is essentially the most dangerous thing a central banker can do, as it risks “unanchoring” inflation expectations.
But the authors argue that history simply doesn’t show this to be the case. Instead, the data suggests that to mitigate the slump in imports as tariffs bite, the central bank must stimulate economic activity, lift employment and boost income. Policymakers must be prepared to “tolerate some overheating,” the authors contend.
This conclusion reflects another important lesson from economic history: tariffs are pretty bad for growth.
A 2020 study using aggregated data for 151 countries from 1963 through 2014 found that tariffs have “economically- and statistically-significant adverse effects” on growth.
The impact is “persistent” and increases over time, the researchers found. Their baseline model suggests that a 3.6 percentage points increase in tariffs results in a 0.4 percent decline in economic output five years later.
They actually found that the projected longer-term effect of tariffs on GDP was higher than the estimated medium-term impacts, but they limited their study to a five-year time horizon “in an effort to be conservative.”
Proceed with caution
Right now, Fed officials are also erring on the side of caution. In their revised economic projections released last month, they maintained their forecast for two quarter-point rate cuts this year, although a hawkish underlying shift in the “dot plot” of officials’ individual projections moved the median closer to one cut.
And Fed Chair Jerome Powell has been at pains to be neutral and non-committal on the question of tariffs, insisting that, before acting, he and his colleagues must wait and see what the actual impact is on activity, prices and employment.
Fed Governor Chris Waller, however, was a bit bolder in a speech to the OECD in Paris in January, stating: “If, as I expect, tariffs do not have a significant or persistent effect on inflation, they are unlikely to affect my view of appropriate monetary policy.”
The market is certainly focusing on the “stag” more than the “flation”. US businesses are reporting the highest factory gate prices in years and consumer inflation expectations are the highest in decades, according to some measures, yet bond yields are falling and interest rate futures are pricing in multiple cuts this year and into 2026. – Reuters
