By Nicole Goodkind

The Federal Reserve has spent the past three years proving it can bring inflation down through tighter monetary policy. But President Donald Trump's sweeping Liberation Day tariffs could spark a new kind of inflation that the Fed is less equipped to handle.

Unlike the demand-driven inflation that the Fed fought after the Covid-19 pandemic, this is a policy-induced supply shock that increases costs directly in ways that monetary policy isn't designed to offset.

Even with a 90-day pause on full implementation of tariffs and the administration's ongoing efforts to negotiate trade deals, the tariffs have already pushed some prices higher. They are projected to increase the average cost of goods and services by 3% this year, according to data from the Budget Lab at Yale University.

Core inflation, excluding food and energy, ran at a 2.6% annual rate in March, as measured by the personal consumption expenditures price index. That was cooler than February's reading and in line with analysts' expectations.

The central bank has few good options if prices continue to climb. Raising interest rates, currently in a targeted range of 4.25% to 4.50%, won't reverse the tariffs or bring down the cost of goods made more expensive due to trade restrictions. Holding the federal-funds rate steady could allow inflation expectations to drift. And cutting rates to cushion the blow of higher prices may reinforce the price increases.

Each of these options carries economic, and potentially political, risk.

"The Fed continues to have an ample set of tools," says Jason Granet, chief investment officer at BNY. "They've got well north of 400 basis points [four percentage points] on the policy rate; they've got the balance sheet, and their words still matter."

Markets are currently pricing in four quarter-percentage-point rate cuts this year, according to the CME FedWatch tool. Beyond the futures market, opinions are split between those who think the Fed will cut more aggressively to stimulate the economy and those who believe the Fed will pause or even raise rates in response to tariffs.

Still, using its tools aggressively could do more harm than good. "It isn't about whether the Fed can ease," says Jake Schurmeier, a portfolio manager at Harbor Capital Advisors. "It's about how long they will have to keep growth slow to bring inflation down."

The most effective tool the Fed may have in this scenario isn't a rate move but a message. If the public trusts that inflation will return to the Fed's 2% target, businesses and workers will be less likely to adjust their behavior in ways that lock in further price growth.

The Fed's credibility was hard-won after the pandemic, especially given its early and erroneous assessment that inflation was transitory. It may lose some of that credibility in the face of new price shocks and Trump's repeated criticism of Fed Chair Jerome Powell for holding interest rates steady this year instead of cutting them.

Trump has ramped up pressure on the Fed and Powell in recent weeks, questioning the Fed's political leanings and saying he wanted to see Powell fired.

Fed officials have said that even if tariffs raise prices sharply, they would be willing to look through the resulting spike so long as employment remains strong.

The median inflation expectation over the next year increased by 0.5 percentage point in March to 3.6%, according to the Survey of Consumer Expectations from the Federal Reserve Bank of New York. That is the highest level since the fall of 2023.

"It is the second-round effects that matter," says Schurmeier. "If wage growth starts to chase tariff-driven prices, the Fed can't look through it anymore."

So far, long-term inflation expectations remain relatively stable, as measured by the New York Fed. But that could change quickly, especially if the Fed appears paralyzed or if political pressure from the Trump administration intensifies.

There's also a possibility that the White House could take a more coordinated approach to influencing monetary policy.

Trump officials have floated the idea of a "shadow Fed chair," or someone pre-emptively crowned as the next Fed chief who would influence policy from beyond the walls of the Eccles Building. Former Fed governor Kevin Warsh is frequently mentioned in this capacity, and he was openly critical of the Powell Fed in a recent high-profile speech questioning the institution's strategy and credibility.

The tension between political loyalty and market credibility raises questions about how monetary policy will evolve if the current Fed chair is sidelined. Even if Powell remains in place until his term ends in May 2026, someone pontificating about policy with White House backing could limit his ability to communicate clearly.

The Fed's balance sheet currently holds $6.7 trillion, down from a peak of nearly $9 trillion, or 36% of gross domestic product, in April 2022. Some observers in Washington and on Wall Street say the Fed should speed up efforts to shrink the balance sheet to reduce the financial system's liquidity and help bring down inflation.

But many economists say that won't make much of a difference if the price increases are owed to trade policy. Moreover, because banks still have far more reserves than they need, the Fed's ability to influence borrowing costs to cool the economy may be weaker than it used to be.

If inflation persists and expectations start to drift, the Fed may be forced to act anyway, tightening policy not because of confidence in its ability to bring prices down, but because failing to act would do more damage to its credibility.

But that decision won't be easy. "Tariffs have brought about so much uncertainty on both ends of the Fed's dual mandate," says Jennifer Appel, principal and senior investment director at NEPC, an investment consulting firm. "If we start to see those job losses come through, there is a risk the Fed will already be behind the curve."

Meanwhile, Powell and his colleagues are likely to rely heavily on communication, emphasizing their long-term inflation target, explaining the nature of the shock, and hoping the public distinguishes between temporary price-level adjustments and more persistent inflationary forces.

That strategy might work. But much depends on the market's willingness to listen.

Write to Nicole Goodkind at nicole.goodkind@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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May 02, 2025 13:21 ET (17:21 GMT)

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