High Inflation and New Tariffs Will Make the Fed’s Job Tougher

High inflation is stoking fresh debate about how the Federal Reserve should respond to President Trump’s sweeping plans to reorder the world economy through tariffs, leading to questions about whether old playbooks still apply.

On Saturday, Mr. Trump is poised to impose 25 percent tariffs on imports from Mexico and Canada as well as an additional 10 percent tariff on Chinese goods. That move comes on the heels of threats to impose hefty tariffs on Colombia, which were rescinded after its government complied with Mr. Trump’s demands to accept deported migrants.

Howard Lutnick, Mr. Trump’s nominee to oversee the Commerce Department and trade, said at a confirmation hearing on Wednesday that he favored “across-the-board” tariffs that would hit entire countries.

The volume of trade policy proposals is making the Fed’s already tricky job even more difficult and sowing uncertainty about what to expect from the central bank as it tries to fully wrestle inflation back to more normal levels.

Tariffs are broadly seen by economists and policymakers as likely to stoke higher prices for U.S. businesses and consumers at least initially, and over time weigh on growth. That, as well as Mr. Trump’s plans to also enact mass deportations, steep tax cuts and reduced deregulation, has complicated the path forward for the Fed, which is debating how quickly to resume rate cuts and by what magnitude after pressing pause this week.

What comes next is far from clear, leaving central bank officials to parse playbooks both old and new to formulate the right strategy.

“The Fed has every intent of following the monetary policy manual that tells you to look through one-time price level shifts, like tariffs, but I worry that reality is messier,” said Ernie Tedeschi, director of economics at the Yale Budget Lab and a former top economic adviser in the Biden administration.

“It will be hard for them to distinguish between different inflationary pressures in the data this year, whether tariffs, immigration, deficits, or non-policy factors,” he said.

The Fed grappled with many of these same issues during Mr. Trump’s first term in office. By 2018, the United States had imposed stiff tariffs on China that were met with retaliatory measures on U.S. products. The trade war upended supply chains and caused businesses across the country to retrench. U.S. importers absorbed much of the increased costs, but consumers ended up paying more for certain products, too.

Transcripts of Fed meetings from that period show that officials were predominantly concerned about the likely hit to growth caused by plummeting business sentiment and a pullback in investment, rather than what they thought would be a one-time but permanent increase in prices.

The idea was that unless there were signs that price pressures were becoming more persistent and that households and businesses were beginning to expect more inflation, the Fed did not need to respond with higher rates.

That view informed the Fed’s decision in the middle of 2019 to deliver cuts that lowered interest rates by 0.75 percentage points, which Mr. Powell billed as an “insurance” policy against flagging economic activity.

Richard Clarida, the former vice chair of the Fed who was involved in formulating the central bank’s response at the time, defended the decision. He said that inflation back then was consistently below the central bank’s 2 percent goal. Also, the potential knock to growth could have been substantial as companies globally turned downbeat.

“We didn’t know what the counterfactual would be,” if the Fed had not done it, he said in an interview.

Today’s circumstances could not look more different, as Mr. Powell acknowledged to reporters at a news conference this week. The legacy of the worst inflation shock in decades still looms large. Interest rates, which were raised above 5 percent to tame rapid inflation, remain higher than prepandemic levels. Prices for groceries and other staples, while not rising as quickly, also remain elevated.

At the same time, the economy has proved extraordinarily resilient, even with high interest rates.

As a result the Fed, after cutting rates by a percentage point in 2024, is in a holding pattern, with its policymakers waiting to see “real progress on inflation or some weakness in the labor market.”

Importantly, while expectations of future inflation among households and businesses have more or less stayed in check, there are early signs that may be changing. According to recent surveys — including a long-running one by the University of Michigan — consumers began to brace for forthcoming price increases as a result of Mr. Trump’s plans to ratchet up tariffs. Some said they planned to buy products in advance to get ahead of…