The paths are based on which direction tariffs might go.
In a speech delivered Monday to the Certified Financial Analysts Society of St. Louis, Federal Reserve Board Governor Christopher Waller outlined two potential scenarios for monetary policy based on how tariffs play out.
“The tariff increases announced April 2 were dramatically larger than I anticipated, adding on to other tariffs announced in March, along with retaliatory actions from some countries,” Waller said. “Combining all of these actions to date, it is clear that tariffs this large and broadly applied could significantly affect the economy and the Federal Open Market Committee’s (FOMC) pursuit of our economic objectives.”
The two big factors Waller is grappling with are the size and permanence of the tariffs. Larger more permanent tariffs could lead to one response while lower, negotiated tariffs could lead to another.
Scenario 1: Large, permanent tariffs
Before the April 2 tariff announcement, the average tariff was below 3%. Even without the reciprocal tariffs, the new 10% tariffs and 125% tariffs on China puts the average effective tariff rate at roughly 25%, Waller said. The estimate is rough and subject to change, but as of now, they are at a level not seen in more than a century.
The first scenario is that tariffs will remain very high and be long-lasting, near the current average of 25% or more. This would signal a committed effort by the Trump administration to engineer a fundamental shift in the U.S. economy toward producing more goods domestically and reducing trade deficits.
In the large tariff scenario, tariffs would increase inflation by 1.5 to 2 percentage points over the next year or so, up from the expected 2.7% in the March PCE.
Also, with large tariffs, Waller would expect the U.S. economy to slow significantly later this year and into next year. Higher prices from tariffs would reduce consumer spending, while uncertainty about the pace of spending would deter business investment, Waller said. Further, productivity growth 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,” he said. “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.”
In addition, slower economic growth would lead to higher unemployment. With the large tariffs in place, the unemployment rate would approach 5% next year.
“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,” Waller said. “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.”
If the slowdown in economic growth is significant and even threatens a recession, then Waller would be in favor cutting rates sooner, and to a greater extent than he previously thought.
“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,” he said.
Scenario 2: Negotiated smaller tariffs
Waller’s second scenario is one where the pauses in reciprocal tariffs are the start of a concerted effort to negotiate reductions in foreign trade barriers. This, in turn, would result in the removal of most of the announced import tariffs and reduce the average tariff rate to around 10%.
“In this case, I would expect the 10% across-the-board tariff to be the baseline for the average trade weighted tariff. Under this scenario the effect on inflation would be significantly smaller than if larger tariffs remained,” Waller said.
In this scenario, he anticipates that the peak effect on inflation could be around 3% annually and would remain anchored as trade negotiations proceed. However, the smaller tariff scenario would still have a negative effect on output and employment growth, but not as significant as the larger tariff scenario.
Thus, citing the limited effects on inflation and economic activity, Waller would support a limited monetary policy response.
“With the threat of a sharp slowdown or recession diminished, pressure to reduce rates based on falling demand would diminish also,” Waller said. “That is, the policy response in this scenario could allow for more patience.”
In that scenario, he said, the outlook for monetary policy might not look much different than it did before March 1.
“With a fairly small tariff effect on inflation, I would expect inflation to continue on its path down towards our 2% target,” Waller said. “In this case, “good news” rate cuts are very much on the table in the latter half of this year.”
Ultimately, the highly uncertain effects of tariffs require policymakers to remain flexible in considering the wide range of outcomes, he concluded.
