As expected, the Federal Reserve left its benchmark federal funds rate unchanged at its March meeting this week. But the more surprising news came at Fed Chair Jerome Powell's post-meeting press conference, where he answered a number of questions regarding the Fed's expectations for inflation, interest rate cuts this year, and President Donald Trump's tariffs.
Interestingly, in one of Powell's answers discussing the potential impact of tariffs on inflation, Powell said the word "transitory." That word infamously dogged him in 2021 and 2022 after he suggested that the post-pandemic increases in inflation would be transitory, and so would moderate without the need for Fed action -- a prediction that turned out to be too optimistic.
In that context, Powell's use of the word "transitory" as it pertains to the threat of inflation today may be giving some investors déjà vu. And investors should certainly be paying attention.
Near-term expectations for growth are slowing as inflation rises
Nearly all experts expected the Federal Open Market Committee to hold interest rates steady at its March meeting, and it did. The focus among watchers was more on how the Fed will proceed later this year, given the level of uncertainty surrounding economic growth and inflation. While Powell's comments about the state of the labor market sounded positive overall, as wages are now growing faster than inflation, he also said that near-term projections for economic growth have slowed while the projections for near-term inflation have risen.
Much of the concern is associated with Trump's trade war, which has involved placing high tariffs on goods from China, Canada, Mexico, and the European Union. Broader tariffs on a wider range of countries are slated to go into effect on April 2, as of this writing. One camp of economists and experts believes that Trump's tariffs will drive up prices for Americans -- in other words, push inflation higher. However, when a reporter asked Powell about what the impact of tariffs on inflation would be, he said it would be difficult to provide a precise answer, but that the Fed would work to separate organic inflation from higher prices caused by tariffs:
... It can be the case that it's appropriate sometimes to look through inflation if it's going to go away quickly without action by us if it's transitory and that can be the case in the case of tariff inflation. I think that will depend on the tariff inflation moving through fairly quickly, and will depend critically as well on ... longer-term inflation expectations being well anchored.
Needless to say, the mere mention of the word transitory led to more questions from reporters, because the last time Powell talked about transitory inflation was right before the Consumer Price Index (CPI) blasted higher in 2021. And although the rates of U.S. inflation have moderated significantly since then, thanks in large measure to the Federal Reserve's interest rate hikes, the price growth that took place during that period hasn't reversed, and consumers and the economy are still adjusting to it.
Later in the press conference, Powell said that the expectation for transitory inflation as a result of tariffs is the Fed's base case right now, but that nobody can be sure yet precisely how much of an impact these higher taxes will have. Part of what makes the prediction so difficult is the fact that while tariffs will increase prices, they are also expected to slow U.S. economic growth. As a result, the economy may end up staying in its current position. Powell also noted that the impacts of the tariffs Trump imposed during his first term turned out to be transitory. The Fed is still penciling in two more 0.25 percentage point interest rate cuts this year, while the market is betting on three.
Image source: Getty Images.
Watch the big three economic indicators
The Fed may think that tariff-driven inflation will prove transitory, but that may not be the case. The bigger takeaway from Powell's latest commentary is that for now, it's uncertain how this trade war will play out in the U.S. economy.
It's also possible that Trump will pivot on tariffs yet again at some point, and shift to smaller tariffs on a longer-term basis.
Ultimately, U.S. investors should watch the big three indicators: economic growth, unemployment, and inflation. As Powell said, if inflation ticks up modestly and gross domestic product comes down slightly, the two may offset one another. Powell also seemed fairly upbeat about the current state of the labor market. However, if inflation rises, growth moderates, and then the unemployment rate rises, the economy may experience stagflation, which seems like a worst-case scenario.
Stagflation was not mentioned in Powell's press conference, and it doesn't seem to be a threat yet, but things can change fast, and if it does occur, that would put the Fed in a bind. If it lowered interest rates to give a lift to a stagnant economy, that could reignite inflation. If it increased rates to fight inflation, that could further slow the economy and push unemployment higher. Neither option would appear to be appealing to the central bank.
