Powell rolls the dice

Federal Reserve policymakers are in a tough spot as they meet this week.

Even before President Trump pushed through new tax cuts, federal spending adjustments and tariffs, the economy was slowing. From 2017 to 2024, annual growth in gross domestic product averaged 2.5%.

The 2018 Tax Cuts and Jobs Act and President Biden’s infrastructure, industrial and social welfare policies increased the federal deficit from 2.9% of GDP in 2016 to 6.6% last year.

Without additional stimulus, economic forecasters in January expected 2.0% growth for 2025. By July, the costs and uncertainty imposed by Mr. Trump’s tariffs had halved that forecast.

The One Big Beautiful Bill Act increases anticipated federal deficits a bit more than $300 billion a year, but Mr. Trump’s tariffs would increase tax revenue by a similar amount.

We haven’t seen the full impact of tariffs, but headline and core inflation are closer to 3% than the Fed’s target rate of 2%.

Corporate America — manufacturers, service providers and retailers — hasn’t pushed through all its increased costs. Going forward, businesses are uncertain about what they will be paying for materials, components and goods for resale.

That can’t last.

In a slowing economy, businesses increase profits by not filling vacant positions, trimming other expenses and boosting productivity, but those strategies have limits.

The University of Michigan and Conference Board surveys of consumer expectations peg one-year inflation at 4.8% and 6.2%, respectively.

Unemployment remains low, but job listings, resignations and layoffs are below pre- and post-COVID-19 shutdown levels, and net hiring is near zero.

For workers with jobs, inflation-adjusted incomes are rising. Those without jobs and new graduates face tough challenges in finding positions.

Businesses are using artificial intelligence to reduce head count, and a stagnant jobs market is creating pessimism among the middle class.

Hence, it’s no surprise that Mr. Trump is pressuring the Fed to lower interest rates.

The president is also considering declaring a national housing emergency to ease building codes and lower tariffs on construction materials. More homebuilding could boost employment and lower inflation; shelter is 35% of the consumer price index. However, construction activity is limited by the availability of buildable land close to large employment centers.

Zoning is inherently a local decision that isn’t easily reformed at the national level.

By lowering monthly payments, lower mortgage rates could make homes more affordable, but homebuyers facing limited supply may use the savings to bid up prices.

The Fed is between a rock and a hard place. If it stands pat, it lets a tough jobs market fester. If it goes through a rate-cutting cycle, it risks making 3% inflation the new normal.

Moreover, the Fed can set the federal funds rate, or the overnight rate that the banks charge one another for funds. However, consumer and business loans often benchmark off the 10-year Treasury rate, which doesn’t always move with the federal funds rate.

From September to December 2024, the Fed lowered the short-term target rate by a percentage point, but increased federal borrowing pushed up the 10-year Treasury and mortgage rates.

Many forces are now supporting that bellwether rate.

AI spending is creating huge demands for new capital. Should Mr. Trump’s tariffs boost manufacturing, expanding factories will be capital-intensive too.

NATO allies in Europe are increasing defense spending. Their coalition governments can’t easily cut social programs, and taxes on the Continent are already burdensome. Hence, European governments will be borrowing more and competing with the U.S. Treasury for international investors’ funds.

The baby boom generation will be drawing down savings during their retirement years, but the smaller cohort that follows is not saving as much for their golden years. On net, that spells a drain on savings available to finance business investment and government debt.

Mr. Trump’s attacks on Federal Reserve independence undermine confidence in U.S. government bonds as a durable store of value, and they will push up interest rates.

Reforms after the global financial crisis discourage banks from making markets in government and corporate debt.

Often, large banks provided a cushion in times of distress — buying bonds during sell-offs — to ease losses for big clients for other services because banks were confident bond prices would eventually rebound, offering them a profit. That cushion is now reduced, making even the best debt instruments (federal debt and top-rated corporate bonds) potentially more volatile. Investors want higher interest rates to compensate.

Consequently, even as the Fed lowers interest rates, a 10-year Treasury rate that is the sum of long-term expected inflation and economic growth — or 4.5% to 5% — is likely the new normal.

Moreover, the Fed can’t fix the structural challenges AI is imposing on labor markets. Many managerial and professional roles are being replaced by software called agents.

Lowering the federal funds rate may take the heat off the Fed from the White House, but historians may well blame Chairman Jerome Powell for locking in inflation at 3%.

• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.