Fight Inflation or Protect Jobs? The Fed Has a Tough Choice to Make

Ivanna Hampton: The Federal Reserve is waiting for clarity. Fed Chair Jerome Powell calls it the right thing to do, as uncertainty over President Trump’s tariffs have raised the risk of higher inflation and unemployment. Meanwhile, the economy is still healthy. So what could force the Fed to make a challenging choice?

Preston Caldwell is a senior US economist for Morningstar Investment Management. Thanks for being here, Preston.

Preston Caldwell: Hey, thanks for having me, Ivanna.

Did the Fed Cut Interest Rates?

Hampton: The Fed left rates unchanged as expected. The committee is again highlighting the risk of higher inflation and slower growth. That sounds a lot like stagflation. Can you explain what that is, and what it could mean for the US economy?

Caldwell: Yeah. I mean, you summed it up. Stagflation is when growth is much below normal but inflation is much above normal, which is unusual. Typically, we think about those variables moving in the same direction. So you can have a little bit higher growth than normal, but the cost may be higher inflation than normal. And growth is obviously good. Growth means the amount of real spending that consumers engage in goes up, and it means that labor markets are in good shape, it’s easy to go out and get a job.

But, you know, inflation is a bad, obviously. So, normally, those two kind of go hand-in-hand. You get a little bit of the good with the bad. And vice versa, if growth is low, then maybe inflation’s lower than normal. But sometimes you can get a situation where you get the worst of both worlds—you have lower growth and higher inflation, and that’s stagflation. And it’s really a spot you don’t want to be in. And it makes the Fed’s job tricky because their goals are pushing them in two separate directions at the same time. They really have no way to put the economy back into balance in a pain-free way in a stagflationary scenario.

Outlook for Inflation and Economic Growth After the Fed Meeting

Hampton: Now, your team changed your forecast for inflation and economic growth in response to Trump’s tariffs. What’s your outlook now?

Caldwell: Yeah. So, stagflation is really what we’re verging into with our latest forecasts. Our forecasts, like pretty much any other economist’s, were upended by the tariffs. We had not expected the tariff increase to be anything as large as it’s turned out to be, starting at the beginning of April when big announcements were really rolled out. And so we previously had thought GDP would grow an annual average of 1.9% in 2025, that’s now 1.2%. We thought it would be 1.6% in 2026, and now it’s 0.8%. So, still positive territory but getting much closer to recessionary territory where you would get an outright decline.

So meanwhile, our inflation forecasts have headed up. We expect inflation to average 3.0% this year and 3.2% next year. So after several years of inflation coming down and getting closer to the Fed’s 2.0% target, it’s now likely to head up a little bit again. And that may be just purely a temporary phenomenon, but, there’s risks that inflation—after the experience we’ve had over the last few years—inflation could become entrenched in the economy and that would be much harder for the Fed to deal with.

What Could Push the Fed Toward Focusing on Inflation or the Job Market?

Hampton: What risks do you think could emerge that could push the Fed to choose between focusing on inflation or the job market?

Caldwell: So going into this, we had expected the Fed to cut by around 200 basis points over the next two years, so we’re currently at a federal fund’s target range of 4.25% to 4.50% percent. We thought that would, sometime by early 2027, get down to 2.50% to two and—uh, sorry, 2.25% to 2.50%, and that’s still our expectation right now. The inflationary shock from tariffs is offset by the recessionary risks and the potential for unemployment to rise. And so those are the two parts of the Fed’s dual mandate. It wants to keep inflation low and stable, and it also wants to keep the economy growing at a healthy rate so that we achieve full employment. But inflation threatens both of those goals.

On the growth side, it would call for lower interest rates than previously expected, but on the inflation side, it would call for higher rates than previously expected owing to higher inflation. So those two kind of cancel out for right now, and so we’re still expecting about 200 basis points of rate cuts over the next two years, but the range of outcomes has become much wider because we don’t know what’s going to happen with tariffs and other policy changes, and then we don’t know how the economy’s going to react to that. And so there’s a credible scenario where the Fed cuts very little over the next two years, maybe not at all because inflation becomes sticky, and maybe we don’t worry as much about a recession, but we have this continually high inflation and so the Fed has to keep monetary policy restrictive.

But then there is a scenario where we do move into a clear, sharp recession sometime perhaps around the beginning of 2026 or at the end of this year and that forces the Fed to cut much more quickly than we expected. Maybe moving the federal-funds rate down by several hundred basis points over the next year or so. So, really a wide range of outcomes, and the Fed is just going to have to wait to see how the economy reacts before it makes its move.

Why ‘Soft’ vs. ‘Hard’ Economic Data Matters to the Fed

Hampton: Now, there were a lot of questions about the difference between soft data and hard data during Powell’s press conference, and basically the different stories that the data’s telling. What’s the debate there, and why does it matter for the Fed?

Caldwell: So basically, if we take something like consumer spending, hard data is like the actual data on consumer spending, like retail sales data, for example, where you go out and you actually measure how much consumers are actually spending. Whereas soft data would be consumer sentiment surveys asking consumers, “What kind of shape are your household finances in?” And I think it’s obvious we prefer the hard data because it’s really more important what people do as opposed to what they say. But sometimes the soft data can be taken as a leading indicator—a prediction—of where the hard data is going to go.

The problem is that there’s been a huge divergence between the hard data and the soft data over the past several years, especially starting around 2021 when inflation surged but consumers kept spending. Even after adjusting for inflation, they were getting, they were buying more goods in real terms than they were before that real spending growth continued to be positive. So there was a huge divergence between the very negative consumer sentiment and actual consumer behavior, and that gap didn’t close. So negative consumer sentiment did not predict a downturn in consumer spending. And so, that suggests that consumer sentiment data, which is one of the main categories of soft data, has become less and less useful. Quite frankly, I pay very little attention to it now just because it’s never had great predictive value and now the predictive value looks essentially zero.

Now, I am looking at some of the, um, the soft data related to business decision-making, like asking businesses, “Has your economic outlook become more uncertain? Are you going to cut back on your spending on equipment and building new plants and other construction projects? Or could you cut back on hiring?” I think that has a little bit more value than the consumer sentiment data. And right now that data is pointing in a very negative direction, but still, though, we don’t know exactly how is that going to translate into the hard data. How, to what degree, are businesses actually going to cut back on their spending? And so we’ll start to get more data on that in coming weeks, but I think the Fed is basically right in wanting to wait for some of the hard data to come in before they start to react.

How the Fed Has Addressed Market Uncertainty in Economic Data

Hampton: And sticking with the data theme, new data on jobs and inflation are set to publish before the Fed’s June meeting while the 90-day tariff pause is still in effect. How has the Fed tried to navigate the uncertainty of the tariffs and timing economic data?

Caldwell: Yeah, so the only data point that we have for April in terms of hard data is the jobs data, which came out last week, which still showed fairly steady conditions in the labor market, which is not surprising because the labor market tends to be a lagging indicator anyway. But, in coming weeks, we’ll get retail sales, and toward the end of the month, we’ll get some data on capital spending by businesses, you know, new equipment purchases and construction activity. We’re gonna start to see actually how the economy is evolving in response to the tariff shock because it was, you know, they were announced at the beginning of April, so we really need to see the April data.

But, even looking beyond that, though, I mean, everyone is so caught off guard that it really probably will take a number of months to get a clear indicator of where the trend is going. And so I think the Fed is really most likely going to wait for a good two to three months of data before they make their assessment and start to react in a major way. And so, that’s why we think probably the first cut in the federal-funds rate will not come until the July meeting. And even then, for the whole second half of this year, I expect the Fed to move fairly slowly just given the uncertainty.

Could the Tariffs Lead to Holiday Shopping Supply Chain Shortages?

Hampton: And spring is a crucial time for the holiday shopping season. Retailors place their orders months ahead of time. Could the tariffs lead to supply shortages?

Caldwell: Well, I think the tariffs are going to engender all manner of disruption in the economy for the rest of this year. But, yeah, indeed, what we see right now is that shipments of goods from China to the US are drying up very quickly. Container ship departures are down something like 60% going from China to the US.

Now there is a big—you know, we don’t know how long-lasting that will be exactly—there was a big stocking up of inventories at the end of 2024 and the beginning of this year to kind of prepare for potential tariffs, and so there’s a little bit of a buffer in the system right now. And we don’t know to what extent retailers will be able to compensate by sourcing goods from non-China countries, which have much lower tariff rates. Again, average tariff rate on China is 145% right now versus 10% for the typical non-China country. We don’t know how much flexibility there will be to reroute production and shipments of goods, but yeah, I think it’s fair to say that the flow of goods into the US is going to diminish and that’s going to cause some combination of shortages and price increases.

You know, if we look back to what happened in 2021 and 2022, it tended to start out with shortages because there was kind of a disequilibrium in the market, and then once prices adjusted upwards, the shortages resolved, but at the cost of having a much higher price to bring the market back into equilibrium. So, yeah, this is a shock that’s going to kind of play out. It’s gonna take something like a year to play out. The inflationary impact will probably not crest until sometime, I would say, in the first quarter of 2026. So, yeah, we’re in for a bumpy road ahead.

Hampton: Well, thank you, Preston, for guiding us through this time. I know the Fed’s going to meet in June. I’m sure you’re going to be digging into the data before then. Thank you for your time today.

Caldwell: Thanks, Ivanna.

Watch Where to Find Investment Opportunities in the Tariff Era for more from Preston Caldwell.