Markets are closely watching the Federal Reserve’s decision on interest rates during its upcoming monetary policy meeting in June. Futures data suggests that the central bank may cut the federal funds rate by 75 to 100 basis points by the end of the year. However, these expectations have been tempered by a cautious stance from Federal Reserve Chairman Jerome Powell, who indicated that current trade policies, particularly the tariffs imposed by former President Donald Trump’s administration, will lead to higher prices and slower growth. This may force the Fed to revise its goals of full employment and price stability. Powell stated, “I strongly believe we will deviate from these goals, possibly for the rest of the year.”
This caution stems from several factors, primarily the significant uncertainty surrounding economic forecasts. Sudden and rapid changes in trade policies, especially tariffs, are unprecedented, making it difficult to predict their precise impact, especially with ongoing policy adjustments. An increase in tariffs could lead to temporary economic growth, as households and businesses rush to make purchases before expected price hikes, as seen in March when car and auto parts sales surged by 5.3%, the largest increase in two years. However, this temporary growth is accompanied by long-term harm to the economy’s structure, as tariffs reduce productivity due to higher import costs, prompting companies to alter their supply chains in search of cheaper alternatives. In the long run, these tariffs redirect economic activity toward locally protected sectors with less competitiveness and lead to a decline in exports, especially to countries like China, which have imposed retaliatory trade measures.
On the other hand, immigration policies also contribute to slowing growth, with data indicating a significant decline in the number of immigrants entering the U.S., coupled with higher deportation rates. This reduction limits the labor supply, negatively affecting productivity, especially in sectors like construction and agriculture, which heavily rely on migrant labor.
In this context, the effectiveness of monetary policy in supporting the economy is limited. Despite slowing GDP growth, the unemployment rate has not changed much, remaining near 4.2%, indicating that the labor market remains somewhat strong. As a result, there may not be enough of a slowdown to justify a rapid rate cut. Additionally, the continued inflation above the Fed’s 2% target for the fifth consecutive year makes the bank cautious, as any hasty rate cut could undermine confidence in price stability. This is highly sensitive, as losing control of inflation expectations could lead to significant economic costs, as was the case in the 1970s when reducing inflation took many years and expensive efforts.
Although some economists and consumers expect short-term inflation to rise, other indicators do not strongly support this view. For instance, data from the New York Federal Reserve, which measures inflation expectations through monthly surveys, has not shown a significant increase, and inflation-linked government bond prices have not reflected a sharp rise in expectations. However, these expectations remain fragile, and changes in them are highly sensitive to the Fed’s actions, making the bank cautious in responding to economic slowdowns to avoid undermining its credibility.
Political pressures also add complexity to the situation. President Trump, as in his first term, continues to pressure the Fed to lower interest rates. However, responding to such pressure could put the Fed in a difficult position, as lowering rates in this environment could be seen as succumbing to political influence, thereby weakening trust in its independence, which is a cornerstone of its credibility with markets and investors. In fact, political pressure may make the Fed more reluctant to take stimulative measures, fearing its decisions could be viewed as not stemming from objective economic assessment.
As a result, the Fed is likely to remain cautious in the coming months, waiting for clearer signals on trade policies and the labor market. If the situation deteriorates sharply, such as if the unemployment rate rises above 4.5%, the Fed may be forced to take more aggressive action. This is based on the “Arrow Rule,” an economic principle suggesting that a half-percentage point increase in the unemployment rate from its lowest level in the past 12 months often signals an early warning of an economic recession. While this rule gave a false alarm last year due to the increase in labor force entrants, the situation is different this year, as the labor market is not growing at the same pace, and any rise in unemployment is more likely to be a result of actual employment slowdown, not just an expansion of the workforce.
Based on all these factors, the most likely scenario is that the Fed will refrain from cutting rates in the near term while keeping the option of broad monetary easing later in the year if conditions warrant it. This scenario seems more probable than the gradual rate cuts some markets are now expecting to begin in June. With caution about inflation, political pressures, and the uncertainty surrounding trade policies, the Fed will continue to carefully balance its goals, sticking to a “wait-and-see” approach until further notice.
