Something Is Rotten at the Federal Reserve

Playing politics with tariff policy is no way to run a central bank

The posture adopted by Federal Reserve Chair Jerome Powell is rapidly undermining the bank’s credibility as an independent and politically neutral institution.

One might look at the economy’s current state, with inflation approaching the 2% target and unemployment holding near 4% and conclude that everything looks fine, interest rates should hold steady. If that were Powell’s position, it would seem respectable.

Instead, he has made a point of going on the record that:

If you just look at the basic data and don't look at the forecast, you would say that we would've continued cutting. The difference, of course, is at this time all forecasters are expecting pretty soon that some significant inflation will show up from tariffs. And we can't just ignore that.

But tariffs are not inflationary. Obviously, tariffs can cause changes in prices. In some respects, that’s their entire purpose. But a change in relative prices, or even a one-time shift upwards in the overall price level, is not “inflation” of the type cognizable for monetary policy. The price increase is not a result of the economy “running hot” or too much money chasing too few goods. It doesn’t continue or compound. As a matter of macroeconomics, raising interest rates is a nonsensical response.

Economists know this. They made a point of calling tariffs inflationary after the inflation of the Biden years, because that word was suddenly salient and provided an opportunity to score political points. But press them on it, and they’ll acknowledge that no, tariffs do not cause inflation.

One way to confirm that economists do not actually believe that tariffs are inflationary is to note that they would never warn that a carbon tax is inflationary. Nor do they ever warn that any increase in any tax is inflationary. Because it’s not. Indeed, if you tell an economist in the abstract that you are concerned about our huge budget deficit and want to raise a tax to narrow it, and ask whether that is likely to be inflationary or deflationary, they will either say it has no effect or that it should exert downward pressure. If you suggest a value-added tax (VAT) as your tool, they’ll applaud your sophistication. If you clarify that the VAT will only be on imports, so actually it’s a tariff… you see the problem here.

If Powell would support rate cuts but-for his concern about tariff-driven inflation, and tariffs are not inflationary, then rates should be cut. (Yes, Powell is only one vote. But we’re talking about what position he should adopt. And we can safely assume that his views reflect those of others at the bank as well.) Perhaps you could construct an inflation story from the concern expressed by many economists that tariffs will reduce output. But raising interest rates would be an odd response; and asking the Federal Reserve to sit in preemptive judgment on which economic policies it believes will be best and worst for growth, raising rates to further slow the economy as a self-fulfilling Caesar’s Thumb Down to policy it dislikes, would transform and politicize the Fed’s role irrevocably.

As I noted back in May, if elected leaders want to prompt higher levels of domestic investment by raising import prices, then preemptively raising interest rates in an effort to counter potential price increases and slow investment is unacceptable—a nakedly political decision intended to frustrate legitimate economic policy. Try to imagine Ben Bernanke announcing a rate hike in response to President Barack Obama’s climate agenda, because of anticipated increases in energy costs. You can’t. Indeed, if one takes seriously the view that tariffs are likely to slow economic growth, then their imposition should strengthen the case for rate cuts, as Treasury Secretary Scott Bessent observed earlier this month.

Making matters worse is the mystery of the missing inflation. Now more than three months post–Liberation Day, with tariffs in place and their revenue running at four times the prior year’s level, their effect should appear in prices. But as the White House Council of Economic Advisers showed in a paper released last week, prices of imported goods are actually rising less quickly than other prices economy-wide. “Retailers have thus far been able to maintain steady availability of imported products at normal prices,” reported Axios, in part because of “the willingness of suppliers and importers to absorb much of the cost of tariffs.” A good example is the decision by Japanese automakers to “slash[] the price of products exported to the US at a record pace, in a sign that companies are sacrificing profits to remain competitive as President Donald Trump’s tariffs hit cars.” You see the problem here.

Asked about this, Powell has put his own confusion on full display. “If you look—ignore the tariffs for a second—inflation is behaving pretty much exactly as we have expected and hoped that it would,” he tried to explain. “We haven't seen effects much yet from tariffs, and we didn't expect to by now.”

But in the very next sentence, “We've always said that the timing, amount, and persistence of the inflation would be highly uncertain, and it's certainly proved that.” So he didn’t expect effects from tariffs yet, but the absence of effects shows how highly uncertain their effects are? “We think the prudent thing to do is to wait and learn more and see what those effects might be. And again, they haven't really shown up.” Were they supposed to show up? You see the problem here.

The best argument one can make for the Fed’s posture is that tariff-induced changes in the price level will be perceived by consumers and businesses as inflation, and either the fear of those increases or their realization will shift inflation expectations higher, which can become a self-fulfilling prophecy. Indeed, consumer expectations for future inflation have shifted higher in recent months. By this rationale, Powell’s position would be that while tariffs are not inflationary, he is publicly warning about the prospect of tariff-induced inflation because people may incorrectly interpret tariffs as inflationary. You see the problem here.

How would a Federal Reserve committed to protecting the U.S. currency and fulfilling its dual mandate of price stability and full employment, with no ideological agenda of its own, respond to an elected president’s decision to impose a tax that would raise the price level as an inducement to greater domestic investment? By signaling strongly with clear public messaging that such a policy must not be confused with inflation and that the bias would be toward reducing interest rates in response to increased demand for productively deployed domestic capital.

If the bank chooses instead to do the opposite, seeking under false pretense and in the absence of supporting data to subvert policy its economists dislike, its case for independence from the political system will be grievously and permanently weakened. It will do more harm to our economy than a tariff ever could.

- Oren