The Federal Reserve is still waiting to see how the tariff shock unfolds before changing interest rates.
As widely expected, the central bank did not change the rates at today’s meeting. Since the 1% point reduction between September and December 2024, federal funding rates have remained within the target range of 4.25% to 4.50%. The rate has been 5.25%-5.50% since July 2023, but rising from nearly 0% during the pandemic constituted the biggest hike in over 40 years.
Even after last year’s cuts, fees are well above the average of 1.7% before the pandemic (2017-19). It sets the expectation that they will eventually fall even further. However, this timing has become very uncertain due to the tariff shock.
We are waiting for clarity before cutting
Fed Chairman Jerome Powell is nothing to speculate, and after the latest central bank meeting he held a particularly silent press conference. He constantly reiterated the need to “wait for greater clarity” and issued other statements about its effectiveness.
Powell pointed out that the US economy looks very healthy before tariffs hit. The economic growth and the labor market were solid. Inflation rose slightly, but the Fed’s 2.0% target (as of March 2025, core PCE inflation was 2.6% year-on-year), but most economists hoped this would be resolved next year or so. This would have called for a gradual reduction in interest rates to more normal levels.
PCE Price Index vs. Core PCE Price Index
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Most economists’ predictions were overthrown by the sudden imposition of the biggest tariffs of the century. The impact on monetary policy remains ambiguous.
How does the economy respond to tariffs?
There are two layers of uncertainty. The first one is about policy. Will customs duties be two months from now (two years from now)? Will fiscal policy change as well? For example, as a tax increase or expenditure, will tariff revenue be recycled into the economy?
Secondly (and equally important), uncertainty about how the economy reacts to tariffs. To what extent do businesses and consumers cut their spending? To what extent can domestic production replace higher cost imports?
As Powell observed, traditional wisdom is that tariffs have a negative effect on actual GDP growth, perhaps to increase unemployment and increase inflation. This creates tension between two parts of the Fed’s mission. A higher unemployment rate and a higher risk of recession will require more aggressive cuts in interest rates than previously expected routes. However, higher inflation will require higher interest rates.
When will the US Fed cut interest rates?
It is unknown which types of impact will be greater. There is a plausible scenario in which the Fed will need to maintain its fees at its current high levels for the next two years to combat inflation. There are also plausible scenarios where the Fed will need to cut hundreds of base points to combat the recession. As Powell said, it’s too early to say, “How does this shake up?”
Currently there is little hard data on the impact of tariffs. Important data for April will be released in the coming weeks. Still, you need at least two to three months of hard data on consumer spending, business investment, labor markets and inflation. The data could send a signal strong enough to push the Fed to cut back in June, but I think the first cut is much more likely in July.
The Federal Government evaluates goal expectations for the July 30, 2025 meeting
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Fix: The charts in previous versions of this article contained false data on the expectations of the Federal Reserve Conference in July.
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