Is the Fed behind the curve?

• Fed is under increasing scrutiny about its decision to delay rate cuts.

• Ongoing tariff uncertainty and resilient economy support Fed’s case for pause.

• But Fed may have left it too late amid some cracks in labour market.

Trump steps up attack on Fed

US President Donald Trump has been relentless in his criticism of the Federal Reserve chair, Jerome Powell, since his return to the White House. From name calling him everything from ‘stupid’ to ‘Mr. Too Late’, Trump has been very public about his dissatisfaction with the Fed going on pause just as he took office.

On the face of it, one might assume that growth concerns are the primary reason why the President is pressing Jay Powell to cut interest rates amid a slowing economy that’s battling heightened trade uncertainty. But Trump’s main worry is the high interest that the federal government has to pay on its debt. Following Congress’s passing of Trump’s ‘Big Beautiful Bill’, which looks set to raise total debt by at least $3 trillion, some analysts are predicting that the annual cost of financing debt interest and repayments will reach $10 trillion. Investors were hoping that a Republican trifecta would lower the debt-to-GDP ratio, not raise it. Instead, the risk of a future US debt crisis has only increased.

The Fed’s dual mandate dilemma

Still, does Trump have a point or is Powell right to stick to his guns on inflation? The Fed has a dual mandate of maintaining price stability while achieving maximum employment. But if policymakers have to prioritize one over the other, inflation always comes out top as without price stability, it would not be possible to have a healthy labour market. Central banks only tend to overlook short-term inflation risks if they can be confident that price pressures will ease over the medium term.

That’s not the case right now for the Fed, as Trump’s trade rampage has clouded the outlook, giving policymakers little clarity about future tariff levels. Powell has been quite explicit in his warning that inflation is expected to head higher over the summer, as the baseline 10% levy rate on most imports introduced on April 2 starts to filter through consumer prices.

Waiting for the tariffs impact

However, several officials believe that any uptick in inflation is likely to be temporary, although this will depend on whether or not further tariff hikes will be announced. On that front, it’s not looking good. While the UK and China won significant tariff reprieves in their respective deals, the Trump administration has been in a less generous mood since those agreements were announced.

Close ally Japan settled for 15% tariffs, Vietnam has been forced to make do with a 20% rate in its deal, while Indonesia’s 19% levy is also almost double the 10% universal duty. More significantly, Trump is threatening its key trading partner, the European Union, tariffs of 30%.

The prospects of lower tariffs for Mexico and Canada are also not great, as Trump has signalled tariffs of 30% for the former and 35% for the latter for goods not covered under the USMCA pact. Moreover, the White House also seems to have set its sights on a blanket levy that exceeds 10% on the remaining, mostly smaller nations that have yet to be notified of their tariffs in a letter.

Are markets hoping for the best?

The hope is that the big trading partners like the EU, Mexico, Canada and India will reach favourable deals that resemble the one that the US signed with the UK before the August 1 deadline. If that turns out to be the case, then there’s a good chance that inflation will rise only modestly over the coming months before falling back. This would pave the way for the Fed to resume its easing cycle in September, as many policymakers are currently flagging.

But what would happen if Trump doesn’t back down over his threats and the average tariff rate on the majority of imports entering the US is set well above 10% and further steep sectoral tariffs are announced? At the moment, all the indications are that businesses are absorbing much of the higher import charges while passing on the remaining costs onto the consumer. If those costs increase further, it will be more difficult for them to absorb the additional expenses and more of the burden will fall on the consumer.

This risk supports the Fed’s caution and the concerns of the more hawkish FOMC members who fear that tariffs may lead to a more persistent pickup in prices. The hawks might even push for a rate increase if inflation continues to accelerate towards the year end instead of receding.

A pause is probably the Fed’s only option

On balance, however, the Fed’s wait-and-see stance appears to be the right one, as the upside risks to inflation far outweigh the downside risks to growth at this point. But this could change, while a handful of market participants think the economy is already headed for recession and are therefore arguing that the Fed has fallen behind the curve.

Looking at the data, there is no conclusive evidence either way that the economy, or specifically the labour market, is in grave danger. Whilst there’s been a notable slowdown in the jobs market, more recently, there appears to be some stabilization. The unemployment rate edged lower to 4.1% in June, potentially peaking at 4.2%.  A similar trend can also be observed with a key subindex of the Conference Board’s consumer confidence survey – the jobs hard to find index. Weekly jobless claims have also fallen lately, further underscoring the view that although hiring has slowed, there are no mass layoffs as of yet.

Other indicators are a bit worrying though, such as the ISM’s employment indices for manufacturing and services, both of which have been in contraction territory for much of the past four months. Consumer spending has also been weakening, while the once red-hot housing market is undergoing a soft patch of its own.

Disinflation risks may be underrated

But the arguments for the Fed to cut rates sooner rather than later are not just based around the cooldowns in consumption and the labour market.  The inflation hawks may be ignoring some of the disinflationary risks such as the decline in energy prices and China’s deflation problem. Aside from domestic deflationary pressures, China may be inducing price reductions globally by dumping the products it’s no longer able to sell to the US due to the higher tariffs onto other countries.

However, with most US inflation metrics still hovering above the Fed's 2% target and core readings printing closer to 3%, Powell’s hawkish inclination is understandable. Another reason for the Fed’s caution has been the upward trend in various measures of inflation expectations. Policymakers will want to see some signs that inflation expectations have peaked on the back of the incoming trade deals before feeling comfortable voting for a rate cut.

Fed’s credibility is at stake

In a stagflationary-type environment such as this, many would argue that the central bank maintaining its credibility on inflation is far more important than preventing a recession, especially when politicians are the source of the economy’s problems. Time will tell if the Fed was prudent to stay on pause for as long as it has, or if Trump’s interference in monetary policy skewed Powell’s judgement in his bid to appear independent from the White House’s influence.