Tariffs, inflation and the long shadow of policy error

Economic

Political

Summary:

Ever since the federal funds rate reached 5.50% in response to generationally high inflation, we’ve expressed concern about the risk of policy error should the U.S. central bank blink by prematurely easing policy before the inflation threat is fully vanquished.

Head of Global Asset Allocation Ashwin Alankar explains how his concerns about premature policy accommodation unleashing a second wave of inflation have grown due to the risks posed by tariffs.

We are not implying that the renowned Spanish philosopher was specifically speaking about monetary policy in 2025 when he penned the statement above, but given the unfolding economic environment, it could be seen as a heads up to the Federal Reserve (Fed).Ever since the federal funds rate reached 5.50% in response to generationally high inflation, we’ve expressed concern about the risk of policy error should the U.S. central bank blink by prematurely easing policy before the inflation threat is fully vanquished. As seen in the chart below, this is what occurred during the 1970s when the Arthur Burns-led Fed – either through miscalculation or losing its nerve – lowered rates before the job was done, thus unleashing a second, even more fierce, inflationary wave.

Tariffs, inflation and the long shadow of policy error_1

Source: Bloomberg, Janus Henderson Investors, as of 18 July 2025. Note: The Atlanta Fed’s designation of “sticky” inflation are those categories whose price levels are slow to change based on their frequency of price adjustments.

As far back as mid-2022, we have identified policy error as a tail risk that could potentially upend the trajectory of a surprisingly extended economic cycle. Importantly, this was before the threat of tariff-related supply distortions emerged. It was also before rumors began circulating about President Trump potentially replacing Fed Chair Jerome Powell with a more dovish successor. These developments – should they unfold in the least favorable manner – would likely make a left-tail, or downside, outcome all the more costly.

What’s at stake

Significant progress has been achieved in the Fed’s battle against inflation once they recognized, and corrected, their transitory blunder. But while headline inflation as measured by the Consumer Price Index (CPI) stands at 2.7%, sticky inflation – an amalgamation of categories that change slowly and account for roughly 70% of CPI – resides at a more worrisome 3.3%.

Within this context, the argument that the fed funds rate – at 4.5% – has considerable room to drop becomes more tenuous. Based on sticky inflation, the fed funds rate is already within striking distance of the level of inflation that matters. Targeting the lower – and noisier – headline could lead to consumer prices ricocheting, resulting in the second major miscalculation of this cycle.

An untimely convergence

The pandemic-era inflationary surge was ignited by supply-chain disruptions and then exacerbated by massive fiscal stimulus. The previously unforeseen impetus for a second wave of inflation could be supply disruptions brought forth by Trump’s trade war.

Meanwhile, a more dovish Fed in 2026 could release a credit impulse in the form of lower rates, potentially spurring demand even as global supply chains and pricing remain in flux. It should be noted that the Fed is governed by a committee, and switching chairs may not result in greater accommodation. But the rhetorical assault on the U.S. central bank is hard to ignore. The potential convergence of supply and demand pressures means both the kindling and matches necessary for a second wave are in place.

An error-driven second wave would back the Fed into a corner with no good choices. Keeping policy accommodative – for whatever the reason – would likely cement inflation expectations at unwanted levels, distorting the important mechanism of price signals across the economy. It would also destroy the Fed’s credibility. The lone alternative would be for the Fed to raise rates – as it was forced to do in the late 1970s and early 1980s – to levels that would almost certainly cause a steep economic downturn.

Source:Janus Henderson

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