The Tariff Trap: Why Fed Hawks Are Betting Against Rate Cuts—and Why Markets Are Wrong

The U.S. Federal Reserve's June 2025 decision to hold interest rates steady at 4.25%–4.5% has reignited debates about whether markets are mispricing the risks of prolonged inflation. At the heart of this tension is a simple truth: tariffs are no longer just trade policy—they're now a structural driver of price pressures, and the Fed is taking notice.

Tariffs: The New Inflation Engine

The historical record is clear. A 2018–2019 analysis by economists at the Federal Reserve Bank of New York found that a 10-percentage-point tariff increase on Chinese imports boosted consumer prices by over 1% in targeted categories. For instance, the May 2019 15% tariff on $180 billion of Chinese goods led to a 2.12-fold pass-through to prices—far exceeding theoretical predictions. This isn't just a “trade war” relic: the April 2025 tariffs alone increased the average U.S. tariff rate by 11.5 percentage points, triggering a 1.3% rise in consumer prices. When combined with all 2025 tariffs, inflation spiked by 2.3%, with apparel prices surging 17% and motor vehicles jumping 8.4%.

The Fed's dilemma? These tariffs aren't going away. President Trump's 2025 announcements—including 25% auto tariffs with U.S. content exemptions and a 10% minimum on non-NAFTA imports—have locked in higher import costs. As Goldman Sachs economists warned in June, “Tariffs are now a baseline inflation risk,” with core PCE inflation projected to hit 3.4% by year-end.

The Fed's Hawkish Reality vs. Market Fantasy

Markets are pricing in two rate cuts by year-end, betting that inflation will retreat as supply chains adjust and demand cools. But Fed officials are skeptical. At the June meeting, Chair Jerome Powell emphasized that “tariff-driven costs are persistent, not transitory”, and warned that geopolitical risks (e.g., Middle East oil disruptions) could amplify prices further.

The Fed's internal “dot plot” for 2025—released in June—showed a median expectation of no cuts this year, with two-thirds of officials projecting hikes or no change. This starkly contrasts with traders' 70% odds of a cut by September. The disconnect? Markets see tariffs as temporary, while the Fed sees them as structural.

Why Rate-Cut Bets Are Mispriced

1. Tariffs Are Sticky
   Unlike past inflation drivers (e.g., oil shocks), tariffs are policy-driven, meaning they won't reverse without explicit government action. Even if demand weakens, higher import costs are here to stay—eroding the Fed's “soft landing” narrative.

2. The Fed's Dual Mandate
   Powell's June press conference highlighted the Fed's dual focus: price stability and full employment. With unemployment at 4.2% and labor markets still resilient, the Fed can't afford to cut rates prematurely. As one Fed official noted, “Rate cuts now would risk a wage-price spiral.”

3. Political Pressures Don't Matter
   Despite Trump's public attacks (“Powell is STUPID for not cutting rates”), the Fed has shown it will prioritize data over politics. The June meeting minutes underscored this: no participant advocated for a cut before seeing clearer inflation signals.

Investment Implications: Avoid Rate-Sensitive Assets

If the Fed stays hawkish and inflation stays elevated, rate-sensitive assets like Treasuries are a losing bet.

• Underweight Treasuries: A 4.5% Fed funds rate and rising inflation mean bond yields will stay elevated. The 10-year Treasury yield is already at 4.2%, but markets are pricing in a drop to 3.8% by year-end—a risky assumption if the Fed holds firm.
• Embrace Inflation-Hedged Equities:
• Energy & Materials: Companies like Chevron (CVX) and Freeport-McMoRan (FCX) benefit from higher commodity prices driven by tariffs and geopolitical risks.
• Consumer Staples with Pricing Power: Procter & Gamble (PG) and Coca-Cola (KO) can pass on cost increases, though their stocks have already rallied—check for dips.
• Real Estate Investment Trusts (REITs): Retail REITs like Simon Property Group (SPG) face headwinds, but industrial REITs (e.g., Prologis LOG) thrive as supply chains adjust.

Conclusion: The Tariff Effect Is Here to Stay

Markets are clinging to the hope that inflation will “just go away.” But the Fed's June 2025 message is clear: tariffs are a permanent feature of the economic landscape. Investors who bet on rate cuts are playing with fire. The smarter move? Position for higher inflation—and higher rates—for the foreseeable future.

Joe Weisenthal is a pseudonym for an analyst who prefers anonymity.