“Tariffs are a stagflationary shock that creates a conundrum for the Fed, which has to decide whether policy should be tightened or eased in response,” point out TD Securities analysts.
“In the current circumstances, we strongly suspect that further escalation in protectionism will lead the Fed to consider easing policy. Increases in inflation should be relatively short-lived, while the hit to growth could be more persistent. In addition, risks are already skewed toward lower inflation and slower growth.”
“The one exception would be if inflation expectations were to rise appreciably in response to tariffs: in that case, the Fed might be willing to consider hikes. However, we see such a scenario as unlikely in the current environment. Also, the Fed would almost certainly try to talk expectations back to its longer-run inflation target before considering any increase in policy rates.”
“While we expect the Fed to ease should the trade war intensify, we don’t expect the Fed to be preemptive in doing so. Rather, Fed officials are likely to wait until there are clear signs of economic weakness before reacting. This approach risks being too little, too late to prevent a deeper contraction in activity if markets were to react sharply and confidence were to stumble. As a result, an outright easing cycle appears more likely than a few “insurance” cuts, in our view.”