Trump and the Fed: battle lines

Good morning. We promised our 2025 predictions would come today, but in the face of yesterday’s consequential Federal Reserve meeting, they will have to wait. We did get a lot of responses on people’s favourite cars, though. They showed Unhedged readers are a sundry bunch. One reader emailed simply “Ferrari 286 GTB”; another talked lovingly of a 2008 Toyota Rav4. Some kept it current with electric cars from Tesla and BMW; others went old school with the Volkswagen T4 camper van or the now-extinct Lancia Kappa. The automobile industry is struggling, but people sure do love their cars. Email us with the worst one you’ve ever owned: robert.armstrong@ft.com and aiden.reiter@ft.com.

The Fed

The possibility of a conflict between the incoming Donald Trump administration’s policies and the Federal Reserve’s price stability mandate has been a topic of discussion since before the election. We have long known — in broad, blurry outline — what the new president’s policy aspirations are. Lower taxes, lower immigration, higher tariffs, a smaller current account deficit. Yesterday came the first intimations — again, broad and blurry — of what the central bank response to all of that might be.

The open market committee cut its policy rate by a quarter point, as expected. But the rub was not in their action, but in their expectations. The Summary of Economic Projections, last seen back in pre-election September, showed a 50 basis point increase in the anticipated policy rate for the end of next year. It now stands at 3.9 per cent, a bit more than two rate cuts from where we stand today. The expectation for 2025 inflation rose 40 basis points, to 2.5 per cent. More significantly, perhaps, the committee’s uncertainty about inflation increased dramatically. The range of members’ 2025 inflation projections, from lowest to highest, was 30 basis points in September. Now it’s 80.

The natural question, faced with this change, is how much the election altered the committee’s outlook. Several journalists asked away, focusing on the inflationary impact of tariffs. Powell’s answer, somewhat disconcertingly, had two distinct aspects. First he said this:

This is not a question that’s in front of us right now. We don’t know when we will face that question. What the committee is doing right now is discussing pathways and understanding the ways in which tariffs can drive inflation in the economy . . . that puts us in [a] position, when we do see what the actual policies are, to make a more careful, thoughtful assessment of what might be the right policy response

This sounds sensible. Then he said this:

Some people [on the committee] did take a very preliminary step and start to incorporate highly conditional estimates of economic effects of policy into their forecasts at this meeting and said so in the meeting. Some people said that they didn’t do so, and some people didn’t say whether they did or not …

Some did identify policy uncertainty [as a reason] for writing down more uncertainty about inflation. And the point about uncertainty is its kind of common sense thinking that when the path is more uncertain you go a little bit slower. It’s not unlike driving on a foggy night or walking into a dark room full of furniture.

In the letter, the two statements are consistent. Together they say that while possible Trump policies did not enter into the rate decision, they did enter into the SEP. In spirit, though, they are inconsistent, because in central banking, expectations are policy. This was visible in the market reaction yesterday. Faced with a Fed that is worried about Trumpy inflation, and thinking more hawkishly as a result, the S&P 500 fell 3 per cent, two-year bonds rose 14 basis points, and 10-year bonds rose 10 basis points. Small-cap stocks, darlings of the Trump Trade, fell hard and have now given up all their post-election gains:

Have the Fed members made a mistake, thinking they know what Trump’s policies will be, and how they will impact the rate trajectory? And in so doing, did they show some political bias? On both fronts, I’d say they probably have. Everyone seems to think they know what the second Trump administration will do. But the president’s mercurial leadership style, his heterogenous cabinet picks, and his party’s narrow margins of control in both houses of Congress mean confidence on this topic is foolish. Arguments that tariff and immigration policy must cause persistent inflation are a bit wobbly, compound the overconfidence problem, and smell of motivated reasoning.

Before condemning Powell and his colleagues, however, remember three things.

One: the committee also had good non-political reasons to increase their inflation expectations. The last two consumer price index inflation readings have been discouraging, and growth has continued to come in hotter than expected. Indeed, plenty of pundits have argued even today’s cut was a mistake (imagine the market reaction if the committee had stood pat!). Some rewriting of the 2025 expectations was already in order; don’t overstate the political aspect.

Second: no plan survives contact with the enemy. We are still in the realm of expectations. The real battle between Trump fiscal policy and Fed monetary policy has not been joined, and when it is, the picture will change. It need not be bloody. Chair Paul Volcker and president Ronald Reagan had a lively tug of war in the 1980s, and the country was just fine.

Finally: do not overread the market’s reaction. Stock valuations are historically high and the bull market has been running for a long time. Expectations that the Fed will cut rates next year are entrenched. In this environment, it will not take much of an increase in rates expectations to whipsaw the stock market. That is something Trump and Powell will both have to keep in mind.

One good watch

From Frankfurt, with love.

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