Federal Reserve Watch for April 14: Inflation Impact From Tariffs Could Be Large, Temporary

The Federal Reserve’s latest analysis of President Trump’s tariffs underscores a pivotal dilemma: while the inflationary shock from tariffs could be significant, policymakers believe it will likely be temporary. Federal Reserve Governor Christopher Waller’s April 14 speech revealed two potential scenarios for the U.S. economy, each with starkly different implications for investors, businesses, and monetary policy.

The Tariff Shock: A Dual-Scenario Outlook

Waller outlined two pathways for the economy, depending on whether tariffs remain at their current elevated levels or are reduced through negotiations.

Scenario 1: High, Persistent Tariffs (25% Average)

If tariffs stay near their current 25% average, inflation could surge to near 5% annually in the short term as businesses pass costs to consumers. Even partial cost absorption could push inflation to ~4%, a sharp rebound from March’s 2.4% CPI reading. However, Waller argued this spike would likely be transitory, akin to a “one-time price-level increase,” with demand weakening and unemployment rising to near 5% by 2026 as growth slows to a “crawl.”

Scenario 2: Negotiated Lower Tariffs (10% Average)

If tariffs ease to 10%, inflation would peak around 3%, aligning with the Fed’s 2% target by 2026. Growth would slow less severely, and unemployment would remain closer to current levels (4.2% in March 2025).

Monetary Policy: Balancing Act Between Growth and Inflation

The Fed’s response hinges on which scenario materializes:
- High Tariffs: Waller hinted at “bad news rate cuts” to avert recession, even if inflation remains elevated. This prioritizes employment risks over transitory price pressures.
- Lower Tariffs: A “wait-and-see” approach could allow the Fed to rely on prior rate cuts (e.g., 2024’s 1% reduction) and wait for data before further adjustments.

Investor Implications: Navigating Uncertainty

1. Sector Rotations:
2. Defensive Plays: Utilities and consumer staples could outperform if recession risks rise under high tariffs.
3. Tech and Industrials: Sectors reliant on global supply chains (e.g., semiconductors) face headwinds from both tariffs and retaliatory measures.

1. Bond Markets:

2. Rising recession risks could boost demand for Treasuries, driving yields lower. The 10-year Treasury yield has already fallen to 3.5% from 4.1% in late 2024.

3. Inflation-Protected Securities:

4. TIPS (Treasury Inflation-Protected Securities) may underperform if inflation proves transitory, but could rally if expectations shift.

Key Risks and Market Miscalculations

• Inflation Expectations: While market-based measures (e.g., TIPS spreads) remain stable, survey data shows households expect higher inflation. A shift in sentiment could force the Fed to tighten further.
• Global Retaliation: Foreign tariffs on U.S. exports, particularly in agriculture and manufacturing, could amplify growth slowdowns.

Conclusion: The Fed’s Delicate Tightrope

Waller’s analysis highlights the Fed’s challenge in navigating a policy environment where tariffs—unlike past inflation shocks—are both self-inflicted and politically charged. While the central bank anticipates transitory inflation, the path to 2% hinges on tariff negotiations, business investment recovery, and labor market resilience.

Investors should prepare for volatility:
- Near-Term: Equity markets may face pressure if inflation spikes to 4–5%, but rate cuts could limit downside.
- Long-Term: Lower tariffs could stabilize growth and reward risk assets, while prolonged tariffs risk a prolonged period of low returns across asset classes.

The Fed’s credibility will depend on its ability to distinguish between a temporary tariff-driven inflation blip and a broader shift in price dynamics. For now, the central bank bets on history repeating—tariffs as a “Tush Push” play that works, this time.

Final Take: Investors must monitor tariff negotiations closely. If talks yield progress, markets could rally on hopes of “good news” rate cuts. If not, prepare for a bumpy ride as the Fed balances recession risks against a temporary inflation surge.