Fed’s Waller Warns of Temporary Inflation Spike from Tariffs, Signals Rate Cut Flexibility

Federal Reserve Governor Christopher Waller’s recent remarks on tariffs and inflation have injected a critical dose of uncertainty into the economic outlook, but also signaled a potential path forward for investors navigating the dual pressures of price stability and growth. Waller, in a speech last month, framed the U.S. tariff hikes as a “one of the biggest shocks to the U.S. economy in decades,” yet argued their inflationary impact would likely be temporary. His analysis hinges on two scenarios—large and smaller tariff outcomes—that offer divergent paths for inflation, growth, and monetary policy.

The Tariff Dilemma: Two Paths for Inflation

Waller’s framework centers on how tariff policies, now averaging 25%—the highest level in over a century—could play out over the next 12–18 months. Under his large tariff scenario, where levies remain at or near 25% through 2027, inflation could surge to 4–5% annually by late 2025 as businesses pass costs to consumers. However, he views this as a “transitory” spike akin to a “one-time price-level increase,” arguing that anchored inflation expectations (evident in Treasury yield spreads) and weaker demand would eventually drag inflation back toward the Fed’s 2% target by 2026.

In contrast, the smaller tariff scenario—where negotiations reduce tariffs to around 10%—would limit inflation to a peak of 3%, with core PCE inflation aligning with the Fed’s goal by late 2025. Waller emphasized that the Fed’s policy response would depend on which path materializes, with rate cuts likely if tariffs persist but growth slows, or a more gradual easing cycle if tariffs ease.

Economic Trade-offs: Growth vs. Inflation

The scenarios also diverge sharply on economic health. Under the large-tariff path, GDP growth would “crawl” as businesses face higher input costs and retaliatory trade measures. Unemployment could rise to near 5% by 2026 from its March 2025 rate of 4.2%, with productivity declining as capital shifts toward politically favored sectors. Waller noted this could force the Fed to implement “bad news cuts”—rate reductions to stave off recession risks, even if inflation remains elevated.

The smaller-tariff path offers a softer landing: moderate GDP growth, unemployment rising only modestly, and business investment rebounding as trade uncertainty eases. Here, the Fed could delay rate cuts until late 2025, relying on ongoing disinflation to justify “good news cuts” as inflation aligns with targets.

Current Conditions and Market Signals

Waller’s analysis is framed by recent data showing progress toward the Fed’s goals. March 2025 PCE inflation stood at 2.3% (headline) and 2.7% (core), down from earlier peaks but still above 2%. The labor market remains robust, with 228,000 jobs added in March, though Waller warned that historical patterns suggest unemployment could rise sharply if growth stalls.

Market reactions to tariff news have been volatile. The S&P 500 fell 1.2% on the April 2 announcement of 25% tariffs but rebounded 0.8% after a 90-day suspension was announced April 9.

Investment Implications: Navigating the Tariff Crossroads

1. Sector Rotations:
2. Defensive Plays: Utilities and consumer staples—sectors less exposed to trade disruptions—could outperform if tariffs persist.
3. Cyclical Caution: Industrials and materials, heavily reliant on global supply chains, face downside risks in the large-tariff scenario.

4. Domestic Winners: Companies benefiting from “reshoring” efforts, such as semiconductor manufacturers or energy firms, may gain if tariffs endure.

5. Rate Expectations:

6. Fed funds futures currently price in a 4.25–4.5% rate through mid-2025, but Waller’s comments suggest cuts could come sooner if growth falters. Monitor the spread between 2-year and 10-year Treasury yields—a key recession indicator—as markets price in policy shifts.

7. Tariff-Exposed Equities:

8. Automakers (e.g., Ford, GM) and tech firms (e.g., Apple) with global supply chains face margin pressures under the large-tariff scenario. Conversely, domestic producers like Caterpillar or Deere might benefit from reshoring demand.

Conclusion: Uncertainty Requires Nimbleness

Waller’s analysis underscores the fragility of the current economic equilibrium. Investors must balance two conflicting risks: inflationary pressures from tariffs and the potential for growth-damaging policy overreach. While Waller’s “transitory” label for tariff-driven inflation offers some comfort, history reminds us that labeling inflation as temporary can backfire.

The Fed’s flexibility—leaning toward preemptive rate cuts if growth slows—provides a cushion, but prolonged tariffs could permanently reshape the economy’s structure. For now, portfolios should prioritize diversification, with a tilt toward defensive sectors and liquidity, while keeping a close eye on trade negotiations and inflation data. As Waller put it, “Just because it didn’t work out once doesn’t mean you shouldn’t think that way again”—a reminder that policy frameworks evolve, but uncertainty remains the only constant.