Fed unlikely to save US economy from tariff impact, says former NY Fed President

Investing.com -- Bill Dudley, the president of the Federal Reserve Bank of New York, has warned that the Federal Reserve may not be able to rescue the US economy from the potentially devastating impact of the tariffs the Trump administration has imposed on imports from most of the world. The weighted-average tariff is expected to climb to 25% or more of the value of imports this year, up from less than 3%.

Dudley predicts that over the next six months, annualized inflation could climb to nearly 5%, as tariffs boost import prices and domestic producers raise their prices. Demand is also likely to decline as businesses delay investments amid uncertainty about the duration and breadth of tariffs and potential foreign retaliation. People may also cut back on spending due to what amounts to a tax hike of $600 billion or more.

The economy’s ability to grow could also be impaired due to deportations and a collapse of immigration, which would undermine the supply of workers, while productivity gains could slow. This could reduce the sustainable rate of real output growth to about 1%, down from 2.5% to 3% last year.

Dudley suggests that stagflation is the optimistic scenario, with a full-blown recession accompanied by higher inflation being more likely. The Federal Reserve usually fights inflation with higher interest rates, which would deepen any recession. Chair Jerome Powell has suggested that it might not need to do so if price increases are temporary and don’t affect expectations of future inflation. This has somewhat encouraged investors, implying that the Fed will focus more on maintaining growth.

However, Dudley casts doubt on the Fed’s conditions being met. First, inflation has been running above the central bank’s 2% target for the fifth consecutive year. Second, shocks that hurt productivity, such as the US tariffs, may have longer-lasting effects on inflation and expectations. Lastly, the Fed’s own actions influence expectations. If people think the central bank is ignoring inflation pressures to focus instead on growth, that perception alone can cause them to anticipate more inflation.

Inflation expectations play a crucial role in determining the cost of fighting actual inflation. If they rise, the unemployment rate may need to rise 2 percentage points above its long-run level to reduce inflation by 1 percentage point in one year. This means recession becomes the Fed’s only option.

Dudley concludes that investors are too optimistic about the likelihood of central bank support. The combination of slower growth, higher inflation and a stubborn Fed won’t be good for stocks. If companies pass along the cost of higher imports to consumers, inflation will be more persistent and the Fed less friendly. If they can’t, profit margins will shrink and earnings will underwhelm. There’s also the risk of foreign tariff retaliation.

For bonds, the main issue will be the trajectory of short-term interest rates. Currently, markets are pricing in more than 100 basis points of easing this year, which Dudley thinks is likely only in the event of an actual economic downturn. Unlike in 2019, when below-target inflation allowed the Fed to cut rates as insurance against recession, the world’s most powerful central bank now has a lot less room for maneuver.

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