Is the Fed waiting for something that won't happen?

I have rarely heard a central bank president say so often that he does not know everything as precisely as during the latest press conference of Fed boss Jay Powell. While President Trump has been demanding rate cuts for a long time, the Fed is waiting for what is to come. And Powell does not know what that will be. He referred to other economic forecasters and noted that they do not come to very different conclusions than the Fed.

Powell did specify the predictors he was talking about. I haven't heard him do that before and it was quite confronting. He was talking about properly resourced institutions. I assume he means that you need an army of economists and econometricians to be taken seriously as a predictor. As a self-employed person I do not qualify, but I console myself with the thought that my forty years of experience offer some compensation. I may not be properly resourced, but certainly richly experienced...

It might not be so bad
Anyway, back to the impact of tariffs on inflation. According to Powell, we are pretty much in the dark. First, we don’t know how high the tariffs will ultimately be. Second, we don’t know what part of the burden of those tariffs will end up with the American consumer in the form of inflation and what part will be absorbed somewhere in the chain by lower margins. Someone has to pay the tariffs. Now there is a battle raging as to who will actually bear the burden. The outcome is uncertain.

According to Powell, however, there is no doubt that the effect on inflation will become visible in the coming period. In surveys, entrepreneurs say that they want to pass on their increased costs. To each other and ultimately also to the end user, the consumer. Powell says he has no idea how big the effect on inflation will be. Maybe I can take a stab at it, although I do not have an army of economists and econometricians at my disposal… I keep it simple.

This would be my approach. You can compare the imposition or increase of an import duty with the increase of VAT. It is essentially a one-off shock. It can lead to a broader inflationary process if the initial shock pushes up long-term inflation expectations, but if the shock is limited, it will be less.

Imports of goods are worth about 11% of US GDP. An average levy of 10% would potentially have a maximum effect on inflation of about 1%. Since some of it will be absorbed in the chain, the actual effect on inflation will be smaller. That doesn't seem like the end of the world to me. Last year's increase in tobacco taxes pushed up Dutch inflation by 0,5%. If I'm right that the effect in the US will be limited to less than 1%, then I don't see much reason for the Fed to worry about that, although it's certainly possible that I'm wrong and that the average levy will be much higher than my assumed 10%.

In the meantime, figures have been published here and there that you might assume show the first effects of the levies on prices. Take the import prices in the US for the month of May. I have to admit that I do not know exactly how this is measured. But those American import prices in May were the same as in January and only 0,2% higher than a year earlier. Also month-on-month there was nothing special visible.

Korea published export prices for May this week. They were slightly lower than in May last year. Again, there was absolutely no worrying picture month-on-month. Perhaps I am trying to draw too many conclusions from these figures, but the figures rather suggest that Korean exporters are absorbing some of the levy. That then limits the effect on US inflation.

It is far too early to draw conclusions. The Fed believes that there will be clear effects of the tariffs on inflation soon. I am inclined to think that there is a significant chance that the Fed is waiting for something that may not come.

Interest rates unchanged, Trump angry
Meanwhile, the Fed has left rates unchanged once again, much to the president's dismay. Most commentary notes that most policy committee members still expect two rate cuts before the end of the year. However, there was a shift in the dot plot. At the previous meeting, four of the committee's 19 members expected rates to remain unchanged this year. That has now risen to seven. It appears that opinions are beginning to diverge somewhat, although the decision to leave rates unchanged was unanimous.

A weakening at the margin
The latest figures suggest that the US economy is weakening somewhat. The homebuilder confidence index fell in June to its lowest level since December 2022. Manufacturing output is growing only very slowly and the number of homes started in May fell to its lowest level since the pandemic. None of this is all that dramatic, by the way. The number of people applying for unemployment benefits is low, but higher than a few months ago.

If that trend continues and I am right that inflation will be limited, then we can expect interest rate cuts by the Fed later this year.

Confidence in Germany slightly stronger 
Analysts' confidence in the German economy is improving. This was also the case earlier this year, as a sign of a cyclical strengthening of the economy. But then came Trump's 'reciprocal' import duties. These gave confidence an exceptionally severe blow in April. When the duties were postponed, confidence recovered. In May and June together, the loss of April was almost made up for. The outlook for the European economy thus remains a plaything of Trump's whims. But: so far, so good.

Closing
The Fed has left interest rates unchanged. Powell et al. are waiting to see how much the import duties will push up inflation. It seems to me that it could be quite a bit less. Simple calculations lead me to that conclusion and the statistics in which the first effects should become visible, show little to nothing alarming.

The US economy is doing reasonably well, but not very exuberantly. On the margin, there is a weakening of the economy. If that continues and inflation is not too bad, that will open the way for interest rate cuts by the Fed later this year.

In Europe, the confidence previously damaged by import duties is recovering. Our growth is not exuberant either, but we are not used to much.

Hans de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on Crystalcleareconomics.nl

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