Jerome Powell's 2025 Inflation Challenge

One has to pity Federal Reserve Chair Jerome Powell as he tries to secure his legacy by meeting the Fed's dual mandate of attaining price stability and maximum employment. Not only will Powell have President-elect Donald Trump now looking closely over his shoulder and putting inordinate pressure on him to keep interest rates low to goose up the economy and the stock market. He will also have to deal with more than the usual degree of policy uncertainty and of external economic and geopolitical instability.

A basic fact that makes monetary policy difficult even in the best of times is that it operates with what Milton Friedman characterized as long and variable lags. This means that it takes time for the full effect of any monetary policy change to work its way through the economy. To make the right interest rate decisions, the Fed has to take a view on the basic forces that will be influencing the economy in the quarters that lie ahead. Next year, those forces will be very much more difficult than usual to gauge.

Start with the economic policy agenda of the incoming Trump administration. On the campaign trail, Trump made a number of radical economic policy commitments. If fully implemented and if not counteracted by higher interest rates, those commitments would drive inflation well past the Fed's two percent inflation target.

A 60 percent tariff on imports from China together with a 10–20 percent import tariff on the rest of our trade partners would cause sharp increases in import prices. The deportation of up to 10 million undocumented immigrants would drive up food prices and building costs given how dependent the agricultural and construction sectors have become on illegal immigrants. Meanwhile, aggregate demand would be boosted substantially by the promised extension of the 2017 Jobs and Tax Cut Act and the elimination of taxes on social security benefits and tips.

A key problem that Powell now has in responding to the incoming Trump administration's economic policy agenda is that he cannot be sure to what extent it will be implemented. Maybe, once Trump takes office, his Treasury Secretary and other responsible adults in the room will persuade him how damaging fully fulfilling his campaign's promises will be to the American and world economies. On the other hand, maybe Trump will persist in carrying out his radical agenda of punitive import tariffs, mass deportations, and budget-busting tax cuts. Only sometime after January 20, once Trump assumes office, will Powell know the answer to that question.

A more basic problem for Powell is that no one can be sure what the impact of Trump's disruptive economic policies will be on the long-run inflation outlook and on the economy's overall performance. On the one hand, as mentioned above, Trump's proposed agenda would add to domestic cost pressures and increase aggregate demand. On the other hand, his policies could provoke a domestic and world financial crisis by causing long-term interest rates to spike and by causing foreign economies to flounder.

A long-term interest rate spike, triggered by a ballooning budget deficit, is the last thing that the troubled domestic commercial real estate sector needs. Such a spike could accelerate the pace of commercial property loan defaults already in evidence. That in turn could lead to another round of the regional bank crisis.

Punitive import tariffs are the last thing that the struggling Chinese and European economies need. China is already having to deal with the bursting of its housing and credit market bubbles at a time when investor confidence in that economy is plunging. Meanwhile, France is in the throes of a budget and political crisis at a time when the export-dependent and energy-intensive German economy has lost its momentum.

As if these were not sufficient causes of US and world economic uncertainty, the Middle East appears to be unraveling as underlined by the recent Syrian revolution. That has to heighten the risk of an international oil price shock given the present hostilities between Israel and Iran and considering the amount of the world oil supply that passes through the Straits of Hormuz.

While the US and world economic outlook is highly uncertain, of one thing we can be sure. If inflation spikes or the economy goes into recession, Powell will feel the full brunt of Trump's rage.

Learn more: The European Central Bank's French Headache | Donald Trump Needs to Worry About the U.S. Economy | Tariffs Would Batter a Fragile Euro Zone | America Is Not an Economic Island

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