Former Fed Vice Chairman: Markets may underestimate the potential for inflation to cool this year

Source: Jinshi Data

Former Fed Vice Chairman and current Pimco Global Economic Advisor Clarida wrote an article reviewing his experience during Trump's first term in 2018-2019 and analyzing the challenges the Fed may face in 2025. Although inflation expectations currently appear to be stable, tariff policies may be less than expected and their uncertainty may pose a resistance to economic growth, which may cause inflation to unexpectedly fall significantly, thereby affecting monetary policy decisions. The full text is as follows.

How the Fed responds to tariffs and handles monetary policy is a hot topic among current market participants and political commentators.

As a former Fed Vice Chairman, my term in 2018-2019 coincided with Trump's first term, and tariffs, trade wars, and trade policy uncertainty also became the focus at the time. It can be seen from the minutes of the Federal Open Market Committee (FOMC), the policy-making body of the Federal Reserve, that the Fed meeting at that time analyzed these factors in detail.

Federal Reserve Chairman Powell recently publicly stated that the Fed's analysis of tariffs and trade policy uncertainty in 2018-2019 is still a good starting point for policy making in 2025.

At the time, inflation was at or below the Fed’s 2% target, and inflation expectations had stabilized after a decade of below-target inflation growth. As a result, the Fed’s analysis concluded that the central bank should be willing to “look past” a one-time increase in import prices driven by tariffs.

However, Powell has also recently emphasized—correctly, I think—that inflation and inflation expectations are set differently in 2025 than they were before.In 2021, inflation was well above the 2% target, and it remains slightly above target today, running at 2.5% over the past year. More importantly, while measures of inflation expectations appear stable for now, Fed officials have said they are not taking it lightly given the inflation overshoot in 2021-2024.

The 2018-2019 analysis also noted that uncertainty from trade policy (and not just trade policy itself) does have macroeconomic consequences and acts as a headwind to growth.In 2019, the ISM manufacturing index fell from 55 to 48, and the core PCE (the Fed’s preferred inflation measure) fell from 2% to 1.5%, below its 2% target. As a result, the Fed responded to the slowdown in economic activity and the decline in inflation by cutting interest rates by 75 basis points between July and November 2019.

Given the current uncertainty about future trade policy and the fact that inflation remains slightly above target, there has been commentary that officials are “in no rush” to cut rates unless they see concrete evidence that inflation is cooling back down and are confident that inflation is on its way back to a 2% path. This is reasonable.

However,I think the market may be underestimating the possibility that inflation will not stagnate this year, but instead begin to decline significantly toward 2%.This may be due to the smaller actual tariff increases and limited pass-through effects than many expected. At the same time, uncertainty about the details of trade policy and the Trump administration’s ambitious tax, spending, and deregulatory agendamay be a headwind to growth.

In this scenario, financial markets may begin to price in more rate cuts based on the Fed's past policy approach. I believe that whether the Fed cuts rates in the scenario I describe will depend on whether it judges that inflation expectations remain anchored.

Of course, it is also possible that increased policy uncertainty may not ultimately pose much of a headwind to growth prospects or financial conditions. For example, on February 3, when the imposition of 25% tariffs on Canada and Mexico was delayed for 30 days, the stock market reversed. On the one hand, such uncertainty may cause businesses to delay hiring and investment decisions; on the other hand, recent activity data suggest that some consumption, trade, and inventory accumulation may have been brought forward in anticipation of tariffs.

It is important to note that foreign manufacturing accounts for only part of a product; a large amount of product value-added comes from sales, marketing, logistics, and intellectual property. Deregulation and policies related to trade and immigration, which affect both supply and demand, may further complicate the monetary policy environment.