Federal Reserve concerns rise as tariff threats expand in scope and intensity.

U.S. Federal Reserve officials are closely monitoring the potential impact tariffs may have on inflation, now recognizing significant risks to supply chains, public expectations, and ultimately prices as the Trump administration's import tax plans become more defined.

The trade war initiated during President Donald Trump's first term led the Fed to reduce interest rates, as the outlook for global and U.S. growth weakened rather than spurring inflation.

With inflation still a primary concern, consumer spending robust, and heightened awareness at the Fed regarding how supply disruptions can lead to persistent inflation, Trump's comprehensive plans are causing alarm.

The administration's fragmented approach may be particularly harmful, Fed officials assert, as businesses and consumers adjust to a future that appears uncertain and inclined toward higher prices.

Trump has increased tariffs on Chinese goods, postponed others on Mexico and Canada, imposed tariffs on imported steel and aluminum starting next month, and instructed his team to prepare duties for any country imposing tariffs on U.S. goods, with more actions potentially forthcoming. Fed officials are concerned these moves could elevate public inflation expectations, risking more sustained price increases.

"Most tariffs result in a one-time shock, and then the world moves on," Atlanta Fed President Raphael Bostic stated earlier this month. However, if debates, implementation, and retaliation extend over time and begin to influence inflation expectations, "it would be appropriate to respond" through monetary policy.

Not all Fed officials share the same level of concern.

Fed Governor Christopher Waller expressed on Monday that he does not foresee tariffs causing persistent inflation and believes central bankers should respond to the data at hand. Waiting for perfect certainty, even in volatile times, "is a recipe for policy paralysis," Waller stated.

Minutes from the Fed's January meeting, expected on Wednesday, may provide further insights into officials' discussions regarding Trump's proposed agenda. The meeting took place just a week after Trump's inauguration, yet uncertainty was already growing, adding to policymakers' hesitance to lower interest rates further until they had more clarity on how Trump's policies would impact the economy.

"Inhibitory Effect"

Administration officials maintain that their plans, which also include tax cuts, deregulation, and immigration crackdowns, will ultimately reduce inflation, a perspective not widely shared by economists.

A recent paper by Boston Fed researchers determined that tariffs of 25% on Mexico and Canada and 10% on China would increase inflation by 0.8 percentage points, challenging the Fed's outlook.

However, the paper noted that this estimate did not account for the numerous adjustments tariffs would trigger: Consumers might switch goods or reduce demand; businesses might absorb the cost or pass it on; other countries might retaliate; and global exchange and interest rates would adjust. "We would expect (such dynamics) to dampen our inflation estimates due to their suppressive effect on economic growth," the authors noted.

That "suppressive effect" dominated during Trump's first term. The price impact was muted, one study found, because retailers absorbed much of the cost through lower profit margins.

This time, Fed officials report business contacts are candid about plans to pass tariff costs to consumers, emboldened by pandemic-era inflation to test their pricing power.

"I do believe that businesses are more likely to pass cost pressures on than they were five years ago," Richmond Fed President Thomas Barkin said in January. Once that process begins, "you'd have to worry about expectations" given that inflation memories remain vivid among consumers.

"In the aggregate, you're...going to see higher prices and lower activity," said Minneapolis Fed research director Andrea Raffo. "How big these forces are depends on...which goods are taxed, and if it is easy to substitute away or not." Uncertainty will cause a further drag.

The Importance of Supply

A survey conducted after Trump's election by economists Olivier Coibion, Yuriy Gorodnichenko, and Michael Weber found about a third of firms were prepared to raise prices, while about half of all respondents expected prices to increase. About 28% accepted Trump's arguments that foreign companies will pay for tariffs.

So far, Fed officials say they don't see consumers or markets losing confidence in the central bank's ability and willingness to return inflation to 2%. With the policy rate at what they still consider a "restrictive" level, they see the stage set for price pressures to ease.

However, warning signs may be surfacing. The University of Michigan's monthly survey showed a rise in consumer inflation expectations, though a similar New York Fed survey remained subdued. Some market-based measures of inflation expectations have also been increasing, though Fed Chair Jerome Powell and other policymakers argue those remain at a level consistent with their 2% inflation target and don't think investors are demanding steadily more in inflation compensation to hold U.S. debt.

Moreover, the combination of conditions - low unemployment, above-trend economic growth, consumers still eager to spend, and businesses newly conditioned to raise prices - could lead to different outcomes than in Trump's first term. Then, output was below the economy's estimated capacity, and inflation largely remained below 2%.

Chicago Fed President Austan Goolsbee emphasizes that recent experience should keep policymakers cautious about how easily the economy will adjust to any tariff shock.

"If in 2018 companies shifted all the easiest things out of China, then what's left might be the least substitutable goods. In that case, the impact on inflation might be much larger this time," Goolsbee said. The impact on complex and integrated supply chains should not be underestimated.

While Trump aims to bring those supply chains onto American shores, the pandemic demonstrated how disruptions and lengthy adjustments can produce more persistent inflation pressure.

"The supply side of the economy cannot be an afterthought," Goolsbee asserted.