Everyday Economics: Stagflationary policy – the economy at a crossroad

The U.S. economy finds itself at a curious intersection with mounting uncertainty as we navigate through the second quarter of 2025. Recent data shows encouraging signs of disinflation, but both the Federal Reserve and market participants remain cautious about several looming challenges.

Inflation: March Progress and April ExpectationsMarch's Consumer Price Index (CPI) data delivered welcome news as prices actually fell by 0.1% during the month. On a year-over-year basis, headline inflation eased to 2.4% from 2.8% previously. Core prices (excluding volatile food and energy) rose by just 0.06% for the month, with the annual core inflation rate moderating to 2.8% from 3.1%. This week, we'll get April's inflation numbers, with economists forecasting a modest 0.2% increase in headline inflation and a 0.3% rise in core CPI. On a year-over-year basis, headline inflation is expected to further ease to 2.3%.

The labor market's cooling also points to lower inflation. Compensation increases have decelerated to levels consistent with price inflation falling below 2% — a key metric the Fed watches closely as a leading indicator of future price pressures.

The Fed's 'Wait-And-See' Approach Is A Risky OneDespite falling inflation and a cooling labor market, the Federal Reserve opted to keep interest rates unchanged at their recent meeting. Fed Chair Powell cited two primary concerns that justify this cautious approach:

Tariff-Induced Supply Disruptions: Recently implemented tariffs could potentially create supply shortages that put upward pressure on prices, temporarily reversing some of the progress on inflation.

Policy Uncertainty: The frequent policy changes from the federal government have created an unusually uncertain economic environment, leading the Fed to adopt a "wait-and-see" approach.

Powell explicitly acknowledged that risks have increased on both sides of the Fed's dual mandate — higher unemployment and higher inflation both represent elevated threats to economic stability. However, he reassured markets that the Fed remains prepared to "act rapidly" should labor market deterioration accelerate.

Economic research supports the view that although higher tariffs could push prices higher initially, the negative demand effects are likely to offset the price pressure with growth and inflation falling below average for a few years after the policy change. Add to that proposed tax hikes along with government spending cuts, and aggregate demand could decline significantly.

Housing Market at a Pivotal PointThis week's housing data releases will provide critical insights into whether the construction sector — a significant contributor to economic activity — is poised for a larger slowdown or continued resilience.

Building permits and housing starts will reveal whether builders anticipate sustained housing demand or are preparing to pull back. With rising housing inventory and anticipated declines in single-family home prices, construction companies may become more hesitant to break ground on new projects.

The implications extend far beyond the housing sector itself. Historically, declines in residential investment have often preceded broader economic downturns. A potential slowdown in construction would likely create drag on labor demand and overall employment growth — developments the Fed is undoubtedly monitoring closely.

Outlook: Balancing Optimism with CautionThe labor market remains balanced. However, several clouds remain on the horizon:

Tariff Effects: The full impact of recent tariffs has yet to be felt in supply chains, business profits, and the labor market.

Housing Market Vulnerability: Given housing's outsized role in economic cycles, any pronounced weakness in construction activity could have amplifier effects.

Policy Uncertainty: Both fiscal and monetary policy appear to be in flux, complicating business planning and investment decisions.

Market participants should pay particular attention to this week's inflation data, housing metrics, and Fed speakers, especially Christopher Waller and Chairman Powell, who may provide further clarity on the timetable for potential rate cuts if disinflation continues.