[By Bill Dudley, translated by Guo Han of Observer Network]
Don't expect the Federal Reserve to come to the rescue of the U.S. economy after the Trump administration imposed epic tariffs on imports from most countries around the world. The only question now is how severe the damage will be.
The president's attack on free trade, in terms of scope, scale, and brutality, is unprecedented. This year, the weighted average tariff rate may rise from less than 3% to 25% or more of the value of U.S. imports. This increase is more than ten times the increase during President Trump's first term.
Its impact will be devastating. Inflation rates could rise to nearly 5% annually within six months, as tariffs push up import prices, and domestic producers raise prices under the protection of trade barriers.
Meanwhile, demand will shrink. Due to uncertainty about the duration, scope, and extent of foreign retaliation against tariffs, companies will delay investment plans. People will cut spending to adapt to an equivalent tax increase of $600 billion or more. Even if Congress passes other tax cuts to offset the impact of these tariffs, given the significant policy lag and the higher income-to-consumption ratio for middle- and low-income households, the harm caused by the tariffs to these families will far outweigh any benefits from the tax cuts.
Worse still, the potential for U.S. economic growth will be impaired. The expulsion and reduction of immigrants will weaken the labor supply, leading to slower productivity growth. This will reduce the sustainable annual growth rate of actual output from last year's 2.5%-3% to around 1%.
In summary, stagflation is the most optimistic outlook for the United States. It is more likely that the U.S. will face a situation where a full-scale recession coexists with high inflation.
What can the Federal Reserve do? It usually raises interest rates to combat inflation, which would inevitably deepen the economic recession. Federal Reserve Chairman Jerome Powell hinted that if price increases are temporary and do not affect future inflation expectations, the Fed may not need to raise interest rates. This statement, to some extent, has boosted investor confidence, indicating that the Fed will focus more on maintaining economic momentum.
On April 4th, local time, Federal Reserve Chairman Powell publicly stated that President Trump's tariff policies were "far beyond expectations," and it was "too early" to adjust monetary policy. Video screenshot.
However, there are good reasons to doubt whether the conditions for the Federal Reserve's actions will be met.
Firstly, the U.S. inflation rate has been above the Federal Reserve's 2% target for a long time. If it exceeds the target for the fifth consecutive year and accelerates, the risk of losing control over inflation expectations will significantly increase.
Secondly, the type of shock is crucial. A shock like imposing tariffs that damages U.S. productivity may have a more lasting impact on inflation and expectations. Recall the two oil price shocks in the 1970s: despite two recessions, inflation persisted. Under the leadership of then-Chairman Paul Volcker, the Federal Reserve had to push short-term interest rates close to 20% to control the situation through deeper economic recessions.
Thirdly, the Fed's own actions influence expectations. If the public believes that the central bank is ignoring inflationary pressures and prioritizing its duty to maintain economic growth, this perception itself will lead them to expect further inflation.
Inflation expectations play a key role in determining the cost of combating actual inflation. When they remain stable, as they have over the past five years, the Federal Reserve can try to prevent unemployment from rising too much. But if expectations rise, the sacrifice ratio will also skyrocket. For example, during events like the oil crisis in the 1970s, the unemployment rate may need to be two percentage points higher than the long-term level to reduce inflation by one percentage point in a year. In other words, an economic recession will become the Federal Reserve's only option.
This asymmetry means that when the U.S. economy is mired in trouble, the Federal Reserve must be extremely cautious. Any monetary easing that stimulates inflation expectations will lead to more stringent and costly tightening measures later. Therefore, I believe investors' expectations of the Federal Reserve coming to the rescue are overly optimistic. Instead, the balance of risks and high economic uncertainty suggest that a more prudent response is reasonable.
When slowing economic growth, high inflation, and a stubborn Federal Reserve come together, it is not good news for the U.S. stock market. This is a lose-lose situation. If companies pass on the additional costs of imports to consumers, inflation will persist, and the Federal Reserve will only become more hawkish. If companies do not pass on the costs, profit margins will shrink and drag down earnings. We haven't even discussed the risk of foreign tariff retaliation here.
For the bond market, the core issue will be the trajectory of short-term interest rates. Currently, the market expects interest rates to fall by more than 100 basis points this year. I believe this will only happen—and should—if the economy actually enters a recession. It is not 2019 anymore, when inflation was below target and the Federal Reserve could lower interest rates as insurance against a downturn. By contrast, the most powerful central bank in the world has lost much of its policy room for maneuver.
(The original article was published on the opinion page of Bloomberg News, with the title "Stagflation is the best outcome for the U.S." The translation is provided for reader reference only and does not represent the views of the Observer Network.)
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