The U.S. economy is searching for a new equilibrium as government policies affecting trade, private investment, and fiscal programs take effect and change the working dynamics of the economy. As the supply and demand of goods and services, labor markets and investment conditions change, they create new risks, new opportunities and great uncertainty. In the middle of this new dynamic, the Federal Reserve is adjusting monetary conditions within which the economy must settle. It now finds itself at the center of controversy as it seeks to find the policy that best serves the economy’s long-term best interests.
At a recent symposium in Jackson Hole, Wyoming, Fed Chairman Jay Powell outlined many of these forces and their potential effects on the economy. He paid particular attention to the balance between employment and inflation. He acknowledged that unemployment remained low and inflation remained above its target, but he was increasingly concerned that given recent adjustment in the employment numbers, the labor market could quickly weaken, slowing consumption and economic growth. While he also recognized that inflation was above the Fed’s target rate, he appeared to put less emphasis on inflation, concluding that “the baseline outlook and the shifting balance of risks may warrant adjusting our policy stance.”
The Fed is in a difficult spot as the economy seeks a new equilibrium. Powell is right to acknowledge the tradeoffs and risks that the Fed must consider in its policy choices. The case for an interest cut isn’t all that clear, however. With high and rising inflation, an ever-increasing national debt and the public’s fear of inflation, the Fed would be wise to wait until the employment and inflation numbers are reported before the September FOMC meeting before hinting at the FOMC’s next move.
Changing Dynamics
The U.S. for decades has consumed more than it has produced, going from the world’s largest creditor to its largest debtor nation. The current administration is seeking to change this balance and advance the nation’s industrial base and global economic standing. It has imposed higher and more volatile tariffs—taxes—on goods and services imported from U.S. trading partners. It is changing the nation’s fiscal policies to promote industrial growth and assure its financial dominance. Such policies, however, carry their own set of risks and tradeoffs. Tariffs are less efficient than free trade and raise the cost of goods and services. Expanding fiscal policies intended to accelerate economic growth often have the unintended consequences of higher inflation, reduced productivity and slower growth.
Reacting to these dynamic changes is the Fed, with its mandate to assure price stability while also pursuing maximum employment and a stable financial system. In the best of times, this is no easy task. The Fed understands, for example, that tariffs meant to protect domestic productions mean higher prices, often slowing the economy and risking higher unemployment and recession. Such outcomes put pressure on the Fed to lower interest rates to stimulate the economy and maintain maximum employment. Offsetting the new tariffs, however, recently enacted fiscal programs will add stimulus to the economy, and lower interest rates may very well intensify inflation . The timing and net effects of these forces are difficult to anticipate and manage as the U.S. economy seeks balance.
Tariffs and Risk to Growth
U.S. tariffs are higher than they have been in nearly a century, averaging between 15% and 18%, and it’s possible they could go higher still. This supply shock is raising the costs of imports and related goods and services and will tend to slow the economy. The recent strong downward adjustment in jobs data and the more modest declines in industrial production and capacity utilization tend to confirm the tariffs’ slowing effects.
It is also unlikely that the full effects of the tariffs have worked through the economy, leaving it vulnerable to further deterioration, perhaps significantly so. And while inflation remains above the Fed’s target of 2%, and tariffs will keep it elevated, it can be argued that their effect is a one-time shift to a higher price level, not ongoing inflation. Also, current inflation is down significantly from its high in 2022 of 9%. Thus, some economists, including some within the Fed, favor cutting rates now as insurance against an economic slowdown or, worse yet, a recession.
Fiscal Policies and Risk of Inflation
Such reasoning has wide support. However, it discounts the probable effects of recently enacted fiscal policy, which provides new tax cuts and subsidies supporting consumer spending and business investments, both designed to stimulate future growth. And while the jobs number have declined in recent months, the unemployment rate remains low at 4.2%, and average hourly earnings continue to outpace inflation at a rate of close to 1.5%.
Credit markets also appear strong. Although the nation’s debt is a growing concern, the market’s access to capital and credit is readily available and financial conditions are accommodative. Loans at U.S. banks increased at a rate exceeding 2%, second quarter over first of 2025, its fastest pace in 3 years. Equity markets are booming with markets achieving new highs almost daily. Overall, while the risks to economic growth are real, the economy appears strong. Fiscal and credit policies are expansionary and supportive of economic growth.
Interest Rates
It remains for the Fed to thread the needle between the contractionary effects of rising tariffs and the expansionary effects of fiscal policy. Should Fed policy focus on avoiding a possible slowdown in activity, or bringing inflation to the Fed’s self-imposed 2% target?
In judging the appropriate policy rate of interest, the Fed often compares the real fed funds rate (nominal fed funds rate less the inflation rate) to an estimate of the equilibrium natural rate of interest, which is the rate in which the economy experiences neither excessive expansionary nor contractionary pressures. Estimates of this rate, called r*, vary, but estimates provided by institutions such as the International Monetary Fund and Bank for International Settlements suggest it may be within a range of 1% to 2%. The nominal fed funds rate is now 4.3%, and CPI inflation is between 2.7% and 3.0%. Thus, the real fed funds rate is between 1.3% and 1.6%, within the range of the neutral rate, r*.
Also, the demand for capital in the U.S. to fund the growing demand for new technology, and the onshoring of manufacturing activities, appear to be accelerating. This trend, added to the rising national debt, would tend to increase r*. Under these conditions, if the Fed were to lower rates, it would imbed or accelerate the economy’s inflationary impulse, undermining stable prices, maximum employment and ultimately financial stability.
The economy is being pushed in different directions as tariffs are imposed on imported goods, raising costs and slowing the economy, while an expansionary fiscal policy keeps aggregate demand taut and inflation above the 2% target and well above price stability. In balancing the risk tradeoff, lowering interest rates in reaction to the tariffs’ effects while ignoring policies that accelerate aggregate demand will most likely worsen inflation and ultimately undermine economic growth.
Loser!