Trade policy drags down the economy beyond expectations, and continued inflation may put decision-makers in a dilemma

Author: Jeff Cox; Source: CNBC
Key Points:

• The minutes of the Federal Open Market Committee (FOMC) meeting on May 6-7 released on Wednesday showed that the Federal Reserve continued to be concerned about the direction of fiscal and trade policies.

• The minutes stated: "Participants said that if inflation persists and the outlook for economic growth and employment weakens, the committee may face difficult trade-offs."

• Since the last rate cut in December last year, the FOMC has kept the benchmark federal funds rate target range unchanged at 4.25%-4.5%, and officials believe that the current policy can well deal with existing risks.

Minutes of the Federal Reserve's May 6-7 Federal Open Market Committee meeting showed that Fed officials were concerned that tariffs could fuel inflation and create a dilemma over interest rate policy.

Minutes of the Federal Open Market Committee meeting on May 6-7 reflected the Fed's continued concerns about the direction of fiscal and trade policy, and officials ultimately decided that the best option was to keep interest rates stable.

"Participants agreed that uncertainty about the economic outlook had increased further, and that a cautious approach was appropriate until the net economic impact of the government's various policy changes became clearer," the minutes said. "Participants noted that the committee could face difficult trade-offs if inflation persisted and the outlook for growth and employment weakened," the minutes also said.

While policymakers expressed concerns about the vagaries of inflation and trade policy, they still said economic growth was "solid," the labor market was "roughly balanced," and consumer spending was continuing despite risks that it could weaken.

Since the last rate cut in December, the FOMC has kept its benchmark federal funds rate target range unchanged at 4.25%-4.5%.

In considering the outlook for monetary policy, participants agreed that the Committee was well positioned to wait for greater clarity on the outlook for inflation and economic activity, given that economic growth and the labor market remain solid and that monetary policy is moderately constrained at the moment.

The post-meeting statement noted that "uncertainty about the economic outlook has increased further." In addition, the committee said that achieving its dual goals of maximum employment and low inflation has become more complicated due to policy uncertainty.

Since this meeting, Fed officials have repeatedly reiterated that they will wait and will not consider another rate cut until fiscal and trade policies become clearer. Market expectations have also responded accordingly, with futures traders now almost pricing in a rate cut before the Fed's September meeting.

Trade policy has also changed since the Fed's last meeting.

Tariffs and ongoing frictions between the United States and China eased a few days after the Fed meeting, after the two countries agreed to suspend most of the tariffs they imposed on each other and enter a 90-day negotiation period. This in turn helped stocks rise on Wall Street, even as bond yields continued to climb, something President Donald Trump has been trying to curb.

Trump has been pressuring Fed officials to cut interest rates amid the trade war and signs that inflation is slowly moving toward the Fed's 2% target. However, Fed Chairman Jerome Powell said the Fed would not be influenced by political interference.

The meeting also discussed the Fed's five-year policy framework.

When officials last reviewed their longer-term policy, they developed what they called “flexible average inflation targeting,” which essentially argues that officials can allow inflation to run above their 2% target for some time as long as it promotes more inclusive labor market gains.

In their discussions, officials noted that the “benefits of that strategy would diminish” if there were “significant risks of a large inflation shock” or if interest rates were not near zero, as they were in the years after the 2008 financial crisis. The Fed kept rates low even as inflation surged in the wake of the coronavirus pandemic, forcing them to take aggressive rate hikes later.

The minutes noted the desire for policy to be “resilient to a variety of economic environments.” Officials also said they had no intention of changing their inflation target.