For weeks, every FOMC member’s appearance has included the sentiments of “policy is in a good place” and “we must remain vigilant against inflation.” As I wrote before, the FOMC has been using any credible excuse to stall to get more clarity on inflation. In other words, their hawkishness wasn’t genuine. Christopher Waller, Federal Reserve Governor in Washington, in a speech on Monday, broke this mold. While he still hedged his message by splitting his comments into two possibilities about tariffs, one if the larger tariffs persist and one if they don’t, he hinted that “larger tariffs” became his base case in March in which he “would expect to favor cutting the FOMC’s policy rate sooner, and to a greater extent”. Several interesting quotes from the speech (indented) and my comments:

Waller says the overall tariff level is basically the same even after the 4/9/2025 90-day pause:

To level set the discussion of tariffs, as of December 2024, the effective average trade-weighted tariff for all imports into the United States was under 3 percent. Earlier this year, targeted tariffs brought the average to 10 percent. The April 2tariffs would have pushed that to 25 percent or more. Even with the pause on implementing those tariffs, retaining the new 10 percent tariff on most imports and a tariff on Chinese imports of well over 100 percent, estimates are that the average effective tariff today is still around 25 percent. This estimate is rough, and we have seen that policy can change quickly, but the point is that even after the 90-day pause, the current tariff rate is a sharp increase to a level that the United States has not experienced for at least a century.

Waller proposes two scenarios, but a hint that he is leaning towards scenario #1:

The “large tariff” scenario assumes that average tariffs around 25 percent will remain in place for some time. Let’s assume they remain at that level until at least the end of 2027, which is the horizon for economic projections made by FOMC participants. In my view, keeping the large tariffs in place this long would be necessary if the primary goal is remaking the U.S. economy, which is now mostly services, into one that produces a larger share of the goods it consumes. Such a shift, if it is possible, would be a dramatic change for the United States and would surely take longer than three years.

In the second scenario, it is assumed that the primary goal would be to use the tariffs as leverage to negotiate reductions in trade barriers faced by U.S. exporters. In this case, while I would expect that the announced minimum 10 percent tariff on all goods from all countries would remain in place, I would also expect that substantially all other tariffs would be eliminated over time. I will call this the “smaller tariff” scenario.

This latter scenario had been my base case up until March 1.

In my view, the primary goal of tariffs isn’t to remake the US economy into a manufacturing economy, it is to replace income tax revenue, which is only meaningful if tariffs persist. Waller says that tariff inflation will be temporary:

While the tariffs after April 9 were very large, I still believe they would have only a temporary effect on inflation.

Market-based inflation expectations are more important than survey-based (i.e., University of Michigan) ones:

It will be important to watch inflation expectations and make sure they remain anchored during this process. Surveys of consumers have shown big increases in inflation expectations for this year. However, I tend to discount survey-based measures of inflation and prefer those based on the spread between nominal and inflation-indexed securities, since investors have more skin in the game than survey respondents. These market-based measures have not increased significantly, which implies market participants view tariffs as a one-time change to the price level. So I don’t think expectations have become unanchored.

Under scenario #1:

Waller expects inflation to rise to 4-5%:

Private sector forecasts expect tariff increases of this magnitude to increase inflation by 1-1/2 to 2 percentage points over the next year or so, which I think is a reasonable estimate. If underlying core PCE inflation were to continue at its estimated 12-month pace of 2.7 percent in March, that would mean inflation could reach a peak close to 5 percent on an annualized basis in coming months if businesses quickly and completely passed through the cost of the tariff. Even if the tariffs were only partially passed on to consumers, inflation could move up to around 4 percent.

He expects growth to slow a lot (or, in central bank-speak, a recession):

In terms of output growth, with large tariff increases, I would expect the U.S. economy to slow significantly later this year and this slower pace to continue into next year. Higher prices from tariffs would reduce spending, and uncertainty about the pace of spending would deter business investment. I have heard this repeatedly from business contacts around the country—tariff uncertainty is freezing capital spending. Productivity growth, an important source of GDP increases in recent years, would slow as investment is allocated according to trade policy and not towards its most productive and profitable uses. A fall in productivity would likely lower estimates of the neutral policy rate, making the current policy rate more restrictive than it is currently. Any trade retaliation from U.S. trading partners would reduce U.S. exports, which would be a drag on growth. There is a long list of factors that can lower growth in this scenario.

He expects unemployment to rise a lot:

Along with slower economic growth would come higher unemployment. With large tariffs remaining in place, I expect the unemployment rate, which was 4.2 percent in March, would rise by several tenths of a percentage point this year and approach 5 percent next year. Even as the economy has moderated over the past year, the unemployment rate has stayed remarkably stable and close to estimates of its long-term rate—in other words, close to the FOMC’s goal. But a verifiable fact about the unemployment rate, based on history, is that when it starts to rise, as I expect it would under this scenario, it often rises significantly.

Inflation will rise, but only temporarily:

In summary, under the large tariff scenario, economic growth is likely to slow to a crawl and significantly raise the unemployment rate. I do expect inflation to rise significantly, but if inflation expectations remain well anchored, I also expect inflation to return to a more moderate level in 2026. Inflation could rise starting in a few months and then move back down toward our target possibly as early as by the end of this year.

The Fed should cut rates sooner and more:

While I expect the inflationary effects of higher tariffs to be temporary, their effects on output and employment could be longer-lasting and an important factor in determining the appropriate stance of monetary policy. If the slowdown is significant and even threatens a recession, then I would expect to favor cutting the FOMC’s policy rate sooner, and to a greater extent than I had previously thought. In my February speech, I referred to this as the world of “bad news” rate cuts. With a rapidly slowing economy, even if inflation is running well above 2 percent, I expect the risk of recession would outweigh the risk of escalating inflation, especially if the effects of tariffs in raising inflation are expected to be short lived.

Under scenario #2:

Here, the peak effect on inflation could be around 3 percent on an annualized basis. Since it may take some time for tariff-related price increases to work their way through production chains, the peak may be lower but still dissipate slowly. As trade negotiations proceed, I would expect that expectations of future inflation would remain anchored and short-term measures could even fall over time, helping keep overall inflation in check. At the same time, the fact that there is still an increase in tariffs means the smaller tariff scenario would surely have a negative effect on output and employment growth, but smaller than the larger tariff scenario. The new tariffs are hitting an economy in good standing, which leaves me encouraged that households and businesses would continue to spend and hire during trade negotiations that lead to substantially reduced import tariffs and possibly remove barriers to U.S. exporters over time. As a result of these limited effects on inflation and economic activity from steadily diminishing tariffs, I would support a limited monetary policy response.

Waller is saying a seemingly counterintuitive thing, that if inflation rises more, the Fed cuts more and vice-versa. The reason is that the Fed is not reacting to inflation here because it is assumed to be short-term while the negative economic effects of tariffs are expected to be long-term (as-in the business cycle). In Powell’s last appearance, he explained that the Fed has written guidance for this; that if both sides of their mandate are in “tension”, to make policy from the longer-lasting one—in this case, labor [video].

James B. Nelson [Milwaukee Journal Sentinel]: One of the questions from the audience that we had is if unemployment takes off and inflation takes off, which lever do you go for? What do you do?

Jerome Powell: So, we actually have a document called our “Consensus Statement” or the longer version is “Statement on Longer-Run goals and Monetary Policy Strategy” and the sixth paragraph of that actually contemplates when the two goals are in tension. What it says is; think about how far each variable is from its goal and think about how long it would take for each to get back.

In other words, if the two goals of inflation and unemployment are equidistant from their goals, policy should focus on the longer-lasting problem. I think that a recession will occur with or without high tariffs because the economy was fully recession-primed prior to Trump’s inauguration. As I wrote before, the trade war is a catalyst, not the cause of a recession and the economy only needed a push which has already happened. That writing also shows that lowering rates with rising inflation is nothing new for the Fed.

Christopher Waller was the pivotal voice in late November 2023 in suggesting cuts could happen sooner which led to the Fed’s first pivot in mid-December 2023 and the 2-year falling 75 basis points. I expect this speech to be a model for other FOMC members to say similar things. Economic data is coming down quickly (updated after today’s data) after the short bump it had in the latter half of March (black arrow in chart below) which gives the Fed some leeway to sound a little more dovish. It would make sense for the Fed to be seeking easier financial conditions through dovishness (lower Treasury yields) at this point to offset how much rates rose last week in opposition to their intended policy or economics.