How Slower Economic Growth and High Inflation Could Affect Interest Rates

Key Takeaways

• There’s any number of directions tariff rates could go—a small increase, a big increase, no increase—from here forward. And depending on that, there’s a lot of different directions that monetary policy could go.
• Given the experience of the last couple of years, people are now paying more attention to inflation and that means that this one-time increase could actually turn out to be more of a prolonged impact.
• It’s pretty unambiguous that tariffs have a negative impact on real GDP.

Ivanna Hampton: Fed Chair Jerome Powell says high uncertainty is behind the move to keep interest rates where they are. Still, he stressed at the Fed’s March meeting that the economy is still solid. Joining me to talk about the meeting is Preston Caldwell. He’s a senior US economist for Morningstar Investment Management.

Thanks for being here, Preston.

Preston Caldwell: Thanks for having me, Ivanna.

Did the Fed Cut Interest Rates?

Hampton: What did you make of the Fed’s decision to hold interest rates steady and pencil in two cuts for 2025?

Caldwell: Well, I mean, virtually everyone expected no cut today, but everyone was looking at what they would be penciling in for the rest of this year, so they left their forecast unchanged compared to the prior projections back issued last December. I guess that was a little surprising, just given that probably the probability of tariff hikes have increased compared to those prior projections. So I think most people would have thought that the Fed would have made some sort of an adjustment for that, which they have, to some extent. There’s a few other moving pieces.

But I think more than anything, if you listen to Powell, when he was pressed on this, he kind of threw up his hand, saying that we don’t know what’s going to happen with the policy at this point. Not only tariffs, but fiscal policy regulation and other factors, but first of all, tariffs. There’s any number of directions tariff rates could go—a small increase, a big increase, no increase—from here forward. And depending on that, there’s a lot of different directions that monetary policy could go, and we don’t know what the effects are going to be. We’re going to have to wait and see how that plays out in the economy in terms of how much gets passed on to consumers, whether it’s a one-time increase or a continual increase.

We’re just going to have to wait for more data before having more certainty around our forecast. Right now, we have to treat the forecast with a bit of a grain of salt.

How Much Will the Fed Cut Interest Rates?

Hampton: Now, your forecast calls for three cuts this year. Why do you see the situation differently?

Caldwell: Well, I mean, two versus three cuts is splitting hairs, but by mid-2027, I do think we’ll get ultimately eight rate cuts altogether, so taking the federal-funds rate down by another 200 basis points, and the Fed is calling for another five rate cuts on that time frame, so 125 basis points—a 75-basis-point gap over the next two and a half years altogether. So that is an important divergence, and part of it is just tariffs. I think right now, I think that the tariff hikes will be on the smaller than the larger side, but then looking at other factors, too, I think economic growth is going to slow a little bit more over the next year and a half. Not go into a recession, but slow enough to reduce inflation further and soften up labor markets and push the Fed to cut a little bit more than they’re projecting.

Odds of Across-the-Board Tariff Hikes Appear Low

Hampton: Powell says that the Fed has baked in tariffs into their forecast for inflation in the months ahead, and also acknowledged that it’s difficult to separate high inflation caused by tariffs from other forces that could push prices higher. You’ve described tariff threat as more fizzle than pop. How should investors view tariffs?

Caldwell: Yeah, so what I was referring to is I just don’t think the tariff hikes are going to be that large outside of China. I think in China, we’ve seen a 20% increase across the board in imports coming from there. Of course, China’s a big country, but even when you single out a single country like that, what we saw back in the 2018 and 2019 trade wars, a lot of imports can be rerouted through other countries to dodge the tariffs.

So it has a significant impact, but it’s somewhat less than having these across-the-board tariffs, which at the beginning of next month, we’ll get a little bit more clarity perhaps on the extent of those tariffs coming from this reciprocal program where the idea is the US is going to match the tariff rate that other countries are charging us according to some formula. There’s a lot of different ways that you can slice and dice the data, but that’s going to entail some sort of across-the-board tariff hike potentially. We don’t really … The details are very uncertain. And then there’s this notion of tariff hikes on Canada and Mexico, which have largely been put on hold for right now.

So there’s a lot of uncertainty, and right now, I’m looking at a 10% across-the-board tariff hike as a catchall for all the different things that could come about. But right now, I think, again, that outside of China, the probability of large across-the-board tariff hikes are relatively low, just looking at the first Trump administration and even what’s happened so far, all of the hubbub about Canada and Mexico tariff hikes, and then most of those ended up being called off at the beginning of this month. It just tends to be the case that the ratio of tariffs that are actually implemented and sustained indefinitely to all the tariffs that are threatened is pretty low, actually. So I’m more in the boat of wait and see before I believe it.

Will Inflation be a One-Time Price Shock?

Hampton: Another question about tariffs: The word transitory came up during Powell’s press conference. Talk about why the Fed might consider the current environment differently from when inflation peaked a few years ago. Can the Fed be confident that inflation is a one-time price shock?

Caldwell: Yeah, I would say it’s uncertain. Now, to be sure, the inflation that we saw was transitory to a great degree because I mean, inflation did come down from over 6% to about 2.5% without the economy slowing down at all, so that doesn’t happen unless it’s the transitory scenario. So it just proved that transitory was a little bit longer than we had hoped for, but it was not permanent by any means. Otherwise, we would have had to have a severe recession to extricate from that inflation.

But I think there was a lasting component that was—we’re not all the way back to 2% today, and the question is how lasting could inflation from tariffs be? And that just depends on really the psychology with which individuals and businesses are operating. In a normal economic environment, people aren’t paying a lot of attention to inflation, and so, if you have inflation go up to 3% or 4% or whatever in a given year, that doesn’t lead workers to start demanding a 4% wage increase from here on out, an extra increase in their wage rate compared to what it normally is to account for that inflation, or businesses don’t start baking in higher inflation into their contracts. So that’s a normal inflationary environment, but given the experience of the last couple of years, I think, the last several years, people are now paying more attention to inflation and that means that this one-time increase could actually turn out to be more of a prolonged impact. So we just really don’t know, and that’s another factor that just compounds the uncertainty here.

But one other point I just want to make, which really hits more of the prior question on what tariffs mean—we talk a lot about the inflationary impact, but inflation is kind of a wash. Prices and wages all go up. So inflation doesn’t matter as much as what’s the impact on real GDP? Because that’s basically the real inflation-adjusted buying power that the average person has. And there, it’s pretty unambiguous that tariffs have a negative impact on real GDP. They decrease the size of the economy because economies are designed so that countries can specialize in what they do best and trade freely with each other, and tariffs stand in the way of that.

So we can be pretty confident, regardless of what happens to inflation precisely and where monetary policy goes, that the tariffs are going to shrink the size of the economy and decrease overall well-being compared to where they would be otherwise.

How Slower Economic Growth and High Inflation Could Affect Interest Rates

Hampton: And how is the Fed balancing the expectations for slower growth and higher inflation?

Caldwell: So there’s a lot of things going on. Like I said, there’s a lot of moving pieces. So at the same time we’ve had this tariff threat, there’s been separate worries about slowing growth with the stock market selling off, and not all of that comes from tariffs. Some of that is particular to tech stocks and more momentum-driven stocks in general, and so that and also a potential consumer slowdown starting in the first quarter.

And so to the extent that growth is slowing, that’s pushing the Fed in the direction of more rate cuts, even at the same time as potential higher inflation pushes in the direction of less rate cuts or even a renewed rate hike potentially. So that’s why those two factors are kind of offsetting, which is why there’s some support for the notion of the Fed still penciling in two rate cuts for this year, unchanged from their prior projection.

Hampton: Preston, thank you for your insights today.

Caldwell: Thanks for having me, Ivanna.

Watch How Inflation, Tariffs, and More Could Affect Your Finances in 2025 for more from Preston Caldwell.