Can the Fed Afford to Look Past Inflation? Waller’s Tariff Dilemma Explained

Federal Reserve Governor Christopher Waller’s recent remarks on the economic impact of tariffs have reignited a critical debate: Can the Fed afford to “look through” rising prices caused by one-time shocks, or does persistent inflation demand a more aggressive response? The answer hinges on two divergent tariff scenarios Waller outlined in a speech earlier this year, each with stark implications for investors.

The Tariff Crossroads: 25% vs. 10%

Waller framed the U.S. economy’s trajectory around two potential outcomes for tariffs on imports, emphasizing their asymmetric effects on inflation, growth, and monetary policy. The stakes are high: the path forward could determine whether the Fed’s credibility as an inflation fighter is preserved or eroded.

Scenario 1: 25% Tariffs – A Brute Shock

A prolonged period of steep tariffs, averaging 25%, would deliver a jolt to prices, potentially pushing headline inflation to nearly 5% in the short term. Waller argued, however, that this spike would be temporary—a “one-time price-level shock” rather than a sustained upward trend. His rationale? Market-based inflation expectations, such as Treasury inflation-protected securities (TIPS) breakeven rates, remain anchored near 2.3%, suggesting investors don’t believe tariffs will permanently distort prices.

But the economic costs could be severe. A 25% tariff scenario would likely slash GDP growth, crimp business investment, and push unemployment toward 5% by 2026. The Fed’s response? Waller hinted at “bad news rate cuts”—preemptive easing to prevent a deeper downturn.

Scenario 2: 10% Tariffs – A Milder Path

A negotiated rollback to 10% tariffs would soften the blow, capping inflation at around 3%. Under this scenario, the Fed could adopt a “good news rate cut” stance, waiting for clearer data before acting. Growth would still face headwinds, but the economy would avoid the brink of recession.

Why “Looking Through” Matters

Waller’s argument for ignoring transitory tariff-driven inflation draws parallels to the 2021–2022 surge, when the Fed initially underestimated supply-chain disruptions. This time, he insists, tariffs are a known, discrete factor—not a symptom of deeper inflationary trends. The Fed’s credibility, he argues, depends on distinguishing between temporary price spikes and persistent imbalances.

The Policy Divide: Waller vs. Powell

Not everyone agrees. Fed Chair Jerome Powell has expressed concerns that supply-chain fragility and labor-market tightness could embed inflation even if tariffs ease. This internal split underscores a critical risk for investors: Fed policy could fragment if officials can’t reconcile their dual mandates of price stability and full employment.

Market Reactions and Investment Implications

Markets have already priced in some of this uncertainty. Waller’s speech contributed to a dip in the U.S. Dollar Index, as traders bet against prolonged rate hikes. Meanwhile, sectors like consumer discretionary and industrials—sensitive to both inflation and Fed policy—have shown volatility.

For investors, the key is to monitor two variables:
1. Tariff Negotiations: Progress toward a 10% tariff resolution could lift risk assets, while a stalemate at 25% would favor defensive plays like utilities or Treasuries.
2. Fed Policy Signals: Watch for Fed communications on “transitory” vs. “persistent” inflation. A shift in tone could trigger a rerating of rate-sensitive sectors like housing or tech.

The Bottom Line: Navigate the Crossroads

Waller’s scenarios suggest that investors face a binary outcome. If tariffs ease, the Fed’s patience could allow equities to grind higher. If not, a prolonged period of elevated inflation—even if temporary—might force the Fed into a tighter corner, squeezing profit margins and multiples.

The data supports caution:
- Inflation expectations (via TIPS) remain subdued, but core PCE (the Fed’s preferred gauge) has cooled to 3.6% year-over-year.
- Unemployment at 4.2% shows labor-market resilience, but a 5% threshold could trigger panic.

Investors should position for both outcomes. Short-term volatility is likely, but the Fed’s ability to “look through” transitory shocks—without sacrificing long-term credibility—will determine whether this becomes a story of resilience or reckoning.

In the end, the Fed’s credibility hangs on a tightrope: balancing today’s tariff-driven inflation with tomorrow’s economic stability. For markets, the path forward is clear—watch the tariffs, watch the Fed, and brace for the crossroads.