Two months into the second Trump administration the Federal Reserve decided to keep their policy interest rate unchanged. That stance will likely continue, though most Fed policymakers expect otherwise.
Tariffs present two different challenges that may point the Fed in different directions. Uncertainty about where we will end up with trade policy may slow business capital spending and hiring, which could lead the Fed to ease interest rates. But tariffs will also cause higher prices, which will feel to consumers like inflation. How will the Fed react to that?
Federal Reserve policymakers will try to fulfill their mandate to keep prices low with maximum employment. Policymakers are human and have opinions about the president, but they will most likely put their political preferences aside as much as they can. Even where I disagree with their policies, I believe that they have high integrity to do what they are charged to do.
Economists have attempted to measure uncertainty, most notably the Economic Policy Uncertainty index. But quantifying the size of policy uncertainty’s effects is extremely difficult. When policy uncertainty is high, other factors also are affecting the economy negatively, so it’s not at all clear the magnitude of uncertainty’s own effect. That said, the logic of an impact is solid, even if quantification is soft.
Policy uncertainty that slows business capital spending and hiring should be countered by stimulative demand management policies. If Congress and the Executive branch do not provide fiscal stimulus, then the Fed will want to cut interest rates to provide monetary stimulus.
However, inflation currently continues above target, and the Fed wants very much to bring inflation down. Most likely, the Fed will wait until hard evidence of weak employment before cutting rates.
Complicating the issue will be tariffs’ impacts on the price level. In a simple example, an increase in tariffs drives a one-time increase in the price level, but not a continuing increase in prices. This will feel like inflation to consumers for a brief period—but not to economists. We economists use the term for persistent, year-after-year increases in prices.
In a more complicated example, though, various tariffs will increase at different times. And they will have different time lags for price level effects. That’s because some sellers of imports will try to hold off on raising prices, while others will move quickly. Some domestic producers will immediately raise their prices to match the higher imported goods prices, but some will drag their feet. This staggered impact on the overall price level feels even more like inflation than the simple example of a one-time, all-of-a-sudden price change.
My end-of-year economic forecast anticipated that the Fed would not respond to tariff-driven price increases: “Fed chairman Jerome Powell referenced studies done in 2018 of policy that ‘sees through’ tariff-driven price increases. The Fed would, hypothetically, compute inflation as if tariffs had not pushed up prices, then conduct policy accordingly.”
Although the Fed will try to see through the tariff effects, their vision will be blurry. The Fed will most likely be cautious about changing interest rates in either direction. Chair Powell used the word “inertia” at the press conference following the March Fed meeting. The policymakers will also worry that the higher perceived inflation might lead consumers to adjust their long-range inflation expectations. The Fed’s models (as well as many private economic models) give a large role to inflationary expectations. So they could feel a need to tighten monetary policy.
But tariff uncertainty could lead them want to cut interest rates to counteract the gloomy business attitudes. When such conflicting pressures present themselves, the status quo has a huge home court advantage.
Some commentators note that Donald Trump, like most real estate developers, prefers low interest rates. The Federal Reserve has a tradition of independence from political pressure, though some individual members may decide to curry favor with the president. Most of them, however, are in a position to be independent without much consequence. They tend not to be politically ambitious.
Through the remainder of 2025 and into 2026 the forces seem balanced between drivers for lower interest rates and driver for tightening. No one can be sure how policy and the economy will turn out, but the best estimate right now is for level interest rates.