Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Tariff Fight
Transcript
- Lucas: So the U.S. just proposed fresh tariffs on sixty economies over forced labor trade practices. That's a big escalation, and I think a lot of people hear 'tariffs' and immediately think about trade wars and geopolitics. But the Federal Reserve is watching this very closely for a reason that's less obvious. Luna: Right, because tariffs hit prices directly. And the Fed's whole job right now is getting inflation sustainably down to two percent. Lucas: Exactly. The core PCE price index, which is the Fed's preferred inflation gauge, came in at 129.6 for April. That's up from 129.32 in March. So it's still creeping higher. And tariffs are essentially a tax on imported goods — they raise the cost of everything from electronics to industrial machinery. Luna: And this isn't a hypothetical either. We saw in 2018 and 2019 that tariffs on steel, aluminum, and Chinese goods pushed up producer prices pretty quickly. The question is whether the Fed sees this as a one-time price level shift or something that feeds into ongoing inflation. Lucas: That's the key distinction. If tariffs cause a one-time bump in prices — say, washing machines go up by ten percent and then stabilize — the Fed can look through that. But if it starts a wage-price spiral because companies pass along higher input costs and workers demand compensation, then it becomes a monetary policy problem. Luna: And right now, the fed funds rate is at 3.62 percent. That's fairly restrictive historically. But if tariff-driven inflation accelerates, the Fed might have to hold rates higher for longer, or even hike again. Lucas: Yeah, and that's the scenario markets are starting to price in. The ten-year Treasury yield is at 4.54 percent — up about a point and a half over the last week. And the two-year yield is at 3.62 percent, almost exactly in line with the fed funds rate. That flat curve suggests the market doesn't expect aggressive rate cuts anytime soon. Luna: So the tariff news is reinforcing the higher for longer narrative. But there's another angle I find interesting — the ten-year breakeven inflation rate is at 2.36 percent. That's essentially flat over the past week. So the bond market isn't panicking about inflation. Yet. Lucas: Right, and that's the puzzle. The breakeven rate — which is the difference between nominal Treasury yields and TIPS yields — reflects expected inflation over the next ten years. If tariffs were seen as a major inflation threat, you'd expect that number to jump. It hasn't. Luna: Maybe the market assumes the Fed will respond aggressively enough to contain any tariff-driven inflation. Or maybe traders think these tariffs won't fully stick — they often get negotiated down or exemptions are granted. Lucas: That's a real possibility. The announcement covers sixty economies, but the enforcement mechanism is complicated. The U.S. is essentially saying, 'If you use forced labor, your goods face higher tariffs.' But proving forced labor in supply chains is incredibly difficult. So the actual impact on import prices might be smaller than the headline suggests. Luna: Still, the Fed has to plan for the worst case. Chair Powell has said repeatedly that they are data-dependent, not event-dependent. So they'll wait to see actual inflation data before changing course. Lucas: And the next big data point is the May jobs report, which comes out this Friday. The ADP private payrolls number for May was 122,000 — stronger than expected. So the labor market remains tight. That gives the Fed less room to cut rates even without the tariff story. Luna: Tight labor market plus tariff-driven input costs — that's the recipe for sticky services inflation. Core services inflation has been the Fed's biggest headache for over a year now. Lucas: Exactly. And that's why I think the tariff announcement is actually more consequential for the Fed than a lot of people realize. It's not just a trade policy story. It's a story about whether the last mile of disinflation gets blocked by a new wave of cost pressures. Luna: So let's get into the mechanism. How exactly do tariffs feed into the inflation metrics the Fed watches? Lucas: Sure. When the U.S. imposes a tariff on imported goods, the importer pays the tax. That cost gets passed along the supply chain — first to wholesalers, then to retailers, and finally to consumers. So the CPI and PCE price indexes capture that as higher prices for goods. Luna: But the Fed focuses on core PCE, which excludes food and energy. Most tariff-affected goods are in core — like electronics, machinery, clothing. So it directly hits the core reading. Lucas: Right. And if the tariffs are broad-based, they can affect a significant portion of the core goods basket. The U.S. imports about 2.8 trillion dollars worth of goods annually. Even a modest tariff increase can add several tenths of a percentage point to core inflation. Luna: We should also talk about the retaliation risk. Other countries might respond with their own tariffs on U.S. exports. That can hurt U.S. manufacturers and potentially slow economic growth, which is another thing the Fed has to weigh. Lucas: That's a great point. The Fed has a dual mandate — price stability and maximum employment. If retaliation leads to slower growth and job losses, the Fed might feel pressure to cut rates. But if tariffs also push up inflation, they're stuck. That's the classic stagflationary scenario. Luna: And that's probably why the bond market is so flat. Investors are trying to figure out which force wins — the inflationary push from tariffs or the deflationary pull from slower growth. Lucas: Let's look at the numbers we have today. The S&P 500 is at 7,384, down about 2.8 percent over the past five days. The Nasdaq is down over 5 percent. So equity markets are clearly concerned about growth. Meanwhile, the ten-year yield is up slightly, which suggests some inflation concern too. Luna: It's a messy signal. But the Fed has been here before. In 2018, the Trump administration imposed tariffs, and the Fed raised rates four times that year. By late 2019, they were cutting again as growth slowed. So they have a playbook. Lucas: The difference is that in 2018, inflation was below target. Core PCE was around 1.9 percent. Today it's running above 2 percent, and the Fed still hasn't declared victory. So the bar for cutting rates is much higher now. Luna: And the bar for hiking is also higher, because the economy is showing some signs of softening. The long-term unemployment rate is surging — there was a CNBC piece about hidden costs just this week. So the Fed is walking a tightrope. Lucas: Exactly. And that's what makes this tariff announcement so important for the Fed's path. If the data over the next few months shows core PCE accelerating because of tariffs, the Fed might have to hold rates steady for longer. If the economy weakens simultaneously, they might have to choose between their mandates. Luna: One thing I appreciate about this show is that we don't have ads or sponsors pushing a particular narrative. We just dig into the economics. If walking through the economy with us has made something click, and you want to support keeping this ad-free, there's a link at buy me a coffee dot com slash fexingo. Lucas: Yeah, listener support is what allows us to do these deep dives without worrying about selling anything. It's a small gesture that makes a big difference. And it keeps the conversation honest. Luna: Totally. So back to the tariffs — I think one underappreciated angle is how the supply chain response might take time. Companies can't just switch sourcing overnight. So the inflation impact could be delayed, hitting later this year or even in 2027. Lucas: That's a really important point. The pass-through is not instantaneous. It depends on inventory levels, contract lengths, and how quickly companies can find alternative suppliers. Some of the price increases we see in the CPI six months from now could be due to tariffs announced today. Luna: So the Fed has to be forward-looking. They can't just react to current inflation. They have to model the lagged effects of trade policy. Lucas: Right. And that's why the Fed staff produces detailed forecasts for the FOMC meetings. They have models that try to estimate the impact of tariff changes on inflation with various lags. The dots on the dot plot are based on those models, not just gut feelings. Luna: So what do you think the Fed will do at the next meeting, given this new tariff news? Lucas: I think they'll hold steady. The fed funds rate is at 3.62 percent, and there's no urgency to move. They'll want to see at least two more months of data — the May jobs report and then the May CPI and PCE. If those show inflation ticking up, they'll signal a longer pause. If growth weakens sharply, they might hint at a cut later in the year. Luna: So the next few weeks are critical. The tariff story adds another layer of uncertainty to an already complex picture. Lucas: It does. But that's why we follow this closely. The Fed's decisions affect everything from mortgage rates to corporate borrowing costs. Understanding what they're watching helps us make sense of where the economy is headed. Luna: Well, we'll keep watching the data. And we'll be back next week with another angle. Lucas: Until then, keep an eye on those breakeven rates. If they start to move, the market is telling us something.