The Fed Affirms Stagflation Risks as Inflation Concerns Grow
A parade of Fed speakers this week reaffirmed key messages from the recent Fed meeting: uncertainty about the economic outlook, some pessimism about inflation and growth this year with risks skewed toward stagflation, and a willingness to wait for more information before adjusting policy. The additional "information" this week, primarily the new 25% tariff on imported motor vehicles and parts, continues to build the case for worse outcomes.
The recent Summary of Economic Projections (SEP) with forecasts from each of the 19 Fed officials provides further insights into their current thinking. While not a consensus forecast, it offers certain clues about their baseline expectations. The median forecast, which is represented by the dashed lines in the chart below, shows PCE inflation slightly higher this year compared to last year. This represents a temporary departure from the downward trend observed since 2022.
Furthermore, the forecasts suggest growth will slow down to just below its longer-run trend after two years of strong growth, with the unemployment rate anticipated to rise marginally. The full range of forecasts (the shaded areas in the chart) reveals a similar narrative, supporting the notion of stagflation as a baseline worry for many officials.
The SEP’s projections indicate disinflation is expected to return in 2026, even when accounting for a half-point reduction in the federal funds rate in 2025. Tariffs are crucial drivers of inflationary pressures in 2025, and Fed officials agree with Chairman Powell that tariff-induced inflation will be transitory. Conditional on economic forecasts, no Fed official deemed it necessary to raise the federal funds rate this year, but four out of the nineteen favored no cuts.
A Shift Towards Stagflation
The median forecast suggests a "whiff" of stagflation in their baseline expectations, reflecting relatively modest hits to growth and higher inflation this year as well as quick, low-pain returns to disinflation next year. However, these projections are far from definitive stagflation forecasts.
Reducing the Federal Funds Rate Ahead?
Atlanta Fed President Rafael Bostic appeared less enthusiastic about reviving the term "transitory," a word the Fed originally used to describe pandemic-era inflation and subsequent rate hikes. Instead, he emphasized higher inflation would necessitate at least one rate reduction in 2024.
Even so, there is some evidence of "pain" from increased inflationary pressures in terms of fewer expected cuts by the Federal Reserve. The median forecast for the federal funds rate suggests a half-point lower projection in both 2025 and 2026 compared to the current figure.
In spite of the new tariff-imposed shock on imported motor vehicles, all Fed officials seem unanimous that their next move is most likely reducing rates, with nearly all showing comfort in cutting this year as inflation rises.
Low Confidence in Economic Projections
The baseline forecasts can’t be taken too seriously due to low confidence expressed by the Federal Reserve. Uncertainty is a key theme in recent communications from the Fed. It has been explicitly mentioned in several statements and press conferences, reflecting high levels of uncertainty about growth, unemployment rates, and inflation.
In fact, the Fed’s uncertainty index—the percentage of officials seeing higher-than-normal uncertainty around their forecasts—is significantly elevated for these core economic metrics.
The forecast uncertainties are not at pandemic peaks but present concerns. Uncertainty concerning inflation was previously reported to be higher than average between June 2021 and December 2022, with growth and unemployment rate forecasts also indicating similarly high levels during that period.
Tighter Monetary Policy and Economic Risks
Despite the overall high uncertainty around economic projections, the baseline forecasts suggest concerns about stagflation risks. Fed officials are aware of these risks but consider policy uncertainty—particularly tariffs—high and therefore hesitant to express strong stances before they see more concrete data on administration plans.
A stagflationary outlook would pose challenges for the Federal Reserve in balancing their dual mandate. Such complexities likely explain the absence of more definitive statements about stagflation risks from the SEP.
Assessing Risks
The SEP has revealed a significant degree of unbalanced risk, mainly toward stagflationary pressures. This indicates Fed officials perceive higher inflation, lower growth rates, and increased unemployment as likelier outcomes.
To better understand these concerns, Fed officials have broken down the various risks into three sectors—growth, inflation, and employment—and weighted them against each other. When compared with previous reports, this recent assessment reflects a marked shift toward stagflationary pressures, even if their baseline forecasts do not explicitly project it.
Potential for Tariff-Induced Inflation
When assessing the impact of tariffs on imported motor vehicles and parts, President Trump’s new 25% tariff could have a similar effect as before: driving costs up and triggering ripple effects.
In particular, this cost shock should result in higher prices for new vehicles and may cause bursts of inflation across other related sectors, including maintenance services, insurance, or car ownership. Assessing the degree to which these inflationary pressures are temporary is crucial for Fed policymakers.
Conclusion
High uncertainty around a forecast typically signals a lack of confidence for economic projections from authorities like the Federal Reserve. Given their baseline risk assessments—weighted toward stagflationary forces—the Powell Federal Reserve appears more cautious and may opt to delay further cuts or even pause monetary tightening policy adjustments.
These uncertainties, combined with an unbalanced set of risks that largely favor lower growth rates, increased inflation, and stagnant employment numbers, offer compelling reasons for caution by the Federal Reserve.
Finally, it should be noted the term "stagflation" has different meanings depending on contextual circumstances. Even so, Fed officials see higher unemployment rates barely above 4% combined with relatively low current inflations (around 2%) do not resemble stagflationary conditions from past recessions in either direction of magnitude or cause.
In an economy still recovering from the pandemic’s shock to global trade and production patterns, we should remain cautious in drawing direct parallels between inflationary pressures today and those observed during previous stagflation episodes.
Unbalanced Risks Remain a Concern
There are multiple reasons why policymakers at the Federal Reserve worry about unbalanced risk. High uncertainty due to ongoing changes to administration policies can lead officials hesitating when forming expectations; another key point to bear in mind is that "tariff-induced inflation" might be more susceptible than ever before to being transitory.
Yet, some concerns cannot be set aside. For instance, the potential for indirect cost effects from the most recent tariffs are much harder to evaluate and mitigate. If medium- to long-term expectations of future inflation rise alongside higher-than-targeted levels today (well above 2% with an economy near full employment), policymakers can’t help but feel an escalating problem ahead.
