Photo of U.S. President Donald Trump and China President Xi Jinping from Reuters.
The tit-for-tat tariff increases the U.S. and Chinese governments have levied on each other’s imports have reached dizzying heights today (April 11). The United States has imposed a tariff rate of 134.7 percent on imports from China, while China has imposed a tariff rate of 147.6 percent on imports from the United States. On all other countries—the rest of the world (ROW)—the United States imposes an average tariff rate of 10.5 percent, which is a sharp increase reflecting the Trump Administration’s imposition of a tariff of at least 10 percent on all countries. The government of China imposes a tariff rate of 6.5 percent on the ROW.
The Peterson Institute for International Economics (PIIE) is a think tank located in Washington, DC. Chad Brown, a senior fellow at PIIE, has created two charts that dramatically illustrate the current state of the U.S.-China trade war. The first chart shows the changes since the beginning of the first Trump Administration in 2017 in the tariff rates the countries have imposed on each other’s imports.
The second chart shows the percentage of each country’s exports to the other country that have been subject to tariffs. As of today, 100 percent of each country’s exports are subject to the other country’s tariffs.
Finally, we repeat a figure from an earlier blog post showing changes over time in the average tariff rate the United States levies on imports. The value for 2025 of 16.5 percent is an estimate by the Tax Foundation and assumes that the tariff rates that the Trump Administration announced on April 2 go into force, although the rates are currently suspended for 90 days—apart from those imposed on China. (An average tariff rate of 16.5 percent would be the highest levied by the United States since 1937.)
Thanks to Fernando Quijano for preparing this figure.
Today (April 10), the Bureau of Labor Statistics (BLS) released its monthly report on the consumer price index (CPI). The following figure compares headline inflation (the blue line) and core inflation (the red line).
The headline inflation rate, which is measured by the percentage change in the CPI from the same month in the previous year, was 2.4 percent in March—down from 2.8 percent in February.
The core inflation rate,which excludes the prices of food and energy, was 2.8 percent in March—down from 3.1 percent in February.
Both headline inflation and core inflation were below what economists surveyed had expected.
In the following figure, we look at the 1-month inflation rate for headline and core inflation—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year. Calculated as the 1-month inflation rate, headline inflation (the blue line) fell sharply from 2.6 percent in March to –0.6 percent—that is, the economy experienced deflation in March. Core inflation (the red line) decreased from 2.6 percent in February to 0.7 percent in March.
Overall, considering 1-month and 12-month inflation together, inflation slowed significantly in March. Of course, it’s important not to overinterpret the data from a single month. The figure shows that 1-month inflation rate is particularly volatile. Also note that the Fed uses the personal consumption expenditures (PCE) price index, rather than the CPI, to evaluate whether it is hitting its 2 percent annual inflation target.
There’s been considerable discussion in the media about continuing inflation in grocery prices. In the following figure the blue line shows inflation in the CPI category “food at home,” which is primarily grocery prices. Inflation in grocery prices was 2.4 percent in March, up from 1.8 percent in February, but still far below the peak of 13.6 percen in August 2022. Although, on average, grocery price inflation has been low over the past 18 months, there have been substantial increases in the prices of some food items. For instance, egg prices—shown by the red line—increased by 108.1 percent in March. But, as the figure shows, egg prices are usually quite volatile month-to-month, even when the country is not dealing with an epidemic of bird flu.
To better estimate the underlying trend in inflation, some economists look at median inflation and trimmed mean inflation.
Median inflation is calculated by economists at the Federal Reserve Bank of Cleveland and Ohio State University. If we listed the inflation rate in each individual good or service in the CPI, median inflation is the inflation rate of the good or service that is in the middle of the list—that is, the inflation rate in the price of the good or service that has an equal number of higher and lower inflation rates.
Trimmed-mean inflation drops the 8 percent of goods and services with the highest inflation rates and the 8 percent of goods and services with the lowest inflation rates.
The following figure shows that 12-month trimmed-mean inflation (the blue line) was 3.0 percent in March, down from 3.1 percent in February. Twelve-month median inflation (the red line) also declined slightly from 3.1 percent in February to 3.0 percent in March.
The following figure shows 1-month trimmed-mean and median inflation. One-month trimmed-mean inflation fell from 3.3 percent in February to 2.6. percent in March. One-month median inflation increased from 3.5 percent in February to 4.1 percent in March. These data are noticeably higher than either the 12-month measures for these variables or the 1-month and 12-month measures of headline and core inflation. Again, though, all 1-month inflation measures can be volatile.
There isn’t much sign in today’s CPI report that the tariffs recently imposed by the Trump Administration have affected retail prices. President Trump announced yesterday that many of the tariffs would be suspended for at least 90 days, although the across-the-board tariff of 10 percent remains in place and a tariff of 145 percent has been imposed on goods imported from China. It would surprising if those tariff increases don’t begin to have at least some effect on the CPI over the next few months. As we noted in this post from earlier in the month, Tariffs pose a dilemma for the Fed, because tariffs have the effect of both increasing the price level and reducing real GDP and employment.
What are the implications of this CPI report for the actions the Federal Reserve’s policymaking Federal Open Market Committee (FOMC) may take at its next two meetings? Investors who buy and sell federal funds futures contracts still do not expect that the FOMC will cut its target for the federal funds rate at its next two meetings. (We discuss the futures market for federal funds in this blog post.) Today, investors assigned only a 29.9 percent probability that the Fed’s policymaking Federal Open Market Committee (FOMC) will cut its target from the current 4.25 percent to 4.50 percent range at its meeting on May 6–7. Investors assigned a probability of 85.2 percent that the FOMC would cut its target after its meeting on June 17–18 by at least 0.25 percent (or 25 basis points).
By the time the FOMC meets again in early May we may have more data on the effects the tariffs are having on the economy.
Congressman Willis Hawley of Oregon and Senator Reed Smoot of Utah (Photo from the U.S. Library of Congress via the Wall Street Journal)
Until last week, the most famous example of the United States dramatically increasing tariffs on foreign imports was the Smoot-Hawley Tariff, which was passed by Congress and signed into law by President Herbet Hoover in June 1930. The website of the U.S. Senate describes the bill as “among the most catastrophic acts in congressional history.”
Did the Smoot-Hawley Tariff cause the Great Depression? According to the National Bureau of Economic Research’s business cycle dates, the Great Depression began in August 1929, well before the passage of Smoot-Hawley. By June 1930, industrial production had already declined in the United States by more than 17 percent. So, even if the downturn had ended at that point it would still have been severe. The contraction phase of the Depression continued until March 1933, by which time industrial production had declined more than 51 percent. That was the largest decline in U.S. history
If Smoot-Hawley didn’t cause the Depression, did it contribute to the Depression’s length and severity? Most economists believe that it did by contributing to the collapse of the global trading system, thereby reducing U.S. exports, aggregate demand, and production and employment.
Some years ago, Tony wrote an overview of Smoot-Hawley that discusses its causes and effects in more detail. A key question in assessing the effects of Smoot-Hawley is the extent to which key trading partners of the United States raised their tariffs in retaliation. The clearest case is Canada, which in 1930 was the leading trading partner of the United States. Canadian Prime Minister William Lyon Mackenzie King and the Liberal Party significantly raised tariffs on U.S. imports in explicit retaliation for Smoot-Hawley. This journal article that Tony co-wrote with two Lehigh colleagues discusses the empirical evidence for this conclusion. (The link takes you to the Jstor site. You may be able to read or download the whole article by clicking on the link on that page and entering the name of your college or university.)
The Trump Administration seems to be attempting a major reordering of the global trading system. A Canadian prime minister in the 1930s tried something similar. Richard Bedford Bennett became prime minister after his Conservative Party defeated Mackenzie King’s Liberal Party in the 1935 Canadian election. Bennett hoped to replace the U.S. market with the markets in England and other countries in the British Commonwealth. He argued that, taken together, the Commonwealth countries had sufficient resources to be largely self-sufficient and need not rely on trade with non-Commonwealth countries. In the end, Bennett was unsuccessful for reasons that Tony and a Lehigh colleague explore in this journal article.
As we’ve noted in earlier posts, according to the usually reliable GDPNow forecast from the Federal Reserve Bank of Atlanta, real GDP in the first quarter of 2025 will decline by 2.8 percent. This morning (April 4), the Bureau of Labor Statistics (BLS) released its “Employment Situation” report (often called the “jobs report”) for March. The data in the report show no sign that the U.S. economy is in a recession. We should add two caveats, however: 1. The effects of the unexpectedly large tariff increases announced this week by the Trump Administration are not reflected in the data from this report, and 2. at the beginning of a recession the data in the jobs report can be subject to large revisions.
The jobs report has two estimates of the change in employment during the month: one estimate from the establishment survey, often referred to as the payroll survey, and one from the household survey. As we discuss in Macroeconomics, Chapter 9, Section 9.1 (Economics, Chapter 19, Section 19.1), many economists and Federal Reserve policymakers believe that employment data from the establishment survey provide a more accurate indicator of the state of the labor market than do the household survey’s employment data and unemployment data. (The groups included in the employment estimates from the two surveys are somewhat different, as we discuss in this post.)
According to the establishment survey, there was a net increase of 228,000 jobs during March. This increase was well above the increase of 140,000 that economists had forecast. Somewhat offsetting this unexpectedly large increase was the BLS revising downward its previous estimates of employment in January and February by a combined 48,000 jobs. (The BLS notes that: “Monthly revisions result from additional reports received from businesses and government agencies since the last published estimates and from the recalculation of seasonal factors.”) The following figure from the jobs report shows the net change in payroll employment for each month in the last two years.
The unemployment rate rose slightly to 4.2 percent in March from 4.1 percent in February. As the following figure shows, the unemployment rate has been remarkably stable in recent months, staying between 4.0 percent and 4.2 percent in each month since May 2024. In March, the members of the Federal Open Market Committee (FOMC) forecast that the unemployment rate for 2025 would average 4.4 percent.
As the following figure shows, the monthly net change in jobs from the household survey moves much more erratically than does the net change in jobs from the establishment survey. As measured by the household survey, there was a net increase of 201,000 jobs in March, following a sharp decrease of 588,000 jobs in February. In any particular month, the story told by the two surveys can be inconsistent with employment increasing in one survey while falling in the other. This month, however, both surveys showed roughly the same net job increase. (In this blog post, we discuss the differences between the employment estimates in the two surveys.)
One concerning sign in the household survey is the fall in the employment-population ratio for prime age workers—those aged 25 to 54. The ratio declined from 80.5 percent in February to 80.4 percent in March. Although the prime-age employment-population is still high relative to the average level since 2001, it’s now well below the high of 80.9 percent in mid-2024. Continuing declines in this ratio would indicate a significant softening in the labor market.
It’s unclear how many federal workers have been laid off since the Trump Administration took office. The establishment survey shows a decline in total federal government employment of 4,000 in March. However, the BLS notes that: “Employees on paid leave or receiving ongoing severance pay are counted as employed in the establishment survey.” It’s possible that as more federal employees end their period of receiving severance pay, future jobs reports may find a more significant decline in federal employment.
The establishment survey also includes data on average hourly earnings (AHE). As we noted in this post, many economists and policymakers believe the employment cost index (ECI) is a better measure of wage pressures in the economy than is the AHE. The AHE does have the important advantage of being available monthly, whereas the ECI is only available quarterly. The following figure shows the percentage change in the AHE from the same month in the previous year. The AHE increased 3.8 percent in March, down from 4.0 percent in February.
The following figure shows wage inflation calculated by compounding the current month’s rate over an entire year. (The figure above shows what is sometimes called 12-month wage inflation, whereas this figure shows 1-month wage inflation.) One-month wage inflation is much more volatile than 12-month wage inflation—note the very large swings in 1-month wage inflation in April and May 2020 during the business closures caused by the Covid pandemic. The March 1-month rate of wage inflation was 3.0 percent, up from 2.7 percent in February. Whether measured as a 12-month increase or as a 1-month increase, AHE is still increasing somewhat more rapidly than is consistent with the Fed achieving its 2 percent target rate of price inflation.
Taken by itself, today’s jobs report leaves the situation facing the Federal Reserve’s policy-making Federal Open Market Committee (FOMC) largely unchanged. There are some indications that the economy may be weakening, as shown by some of the data in the jobs report and by some of the data incorporated by the Atlanta Fed in its pessimistic nowcast of first quarter real GDP. But the Fed hasn’t yet brought inflation down to its 2 percent annual target.
Looming over monetary policy is the fallout from the Trump Administration’s implementation of unexpectedly large tariff increases. As we note in this blog post, a large unexpected increase in tariffs results in an aggregate supply shock to the economy. In terms of the basic aggregate demand and aggregate supply model that we discuss in Macroeconomics, Chapter 13 (Economics, Chapter 23), an unexpected increase in tariffs shifts the short-run aggregate supply curve (SRAS) to the left, increasing the price level and reducing the level of real GDP.
The effect of the tariffs poses a dilemma for the Fed. With inflation still running above the 2 percent annual target, additional upward pressure on the price level is unwelcome news. The dramatic decline in both stock prices and in the interest rate on the 10-Treasury note indicate that investors are concerned that the tariffs increases may push the U.S. economy into a recession. The FOMC can respond to the threat of a recession by cutting its target for the federal funds rate, but doing so runs the risk of pushing inflation higher.
In a speech today, Fed Chair Jerome Powell stated the following:
“We have stressed that it will be very difficult to assess the likely economic effects of higher tariffs until there is greater certainty about the details, such as what will be tariffed, at what level and for what duration, and the extent of retaliation from our trading partners. While uncertainty remains elevated, it is now becoming clear that the tariff increases will be significantly larger than expected. The same is likely to be true of the economic effects, which will include higher inflation and slower growth. The size and duration of these effects remain uncertain. While tariffs are highly likely to generate at least a temporary rise in inflation, it is also possible that the effects could be more persistent. Avoiding that outcome would depend on keeping longer-term inflation expectations well anchored, on the size of the effects, and on how long it takes for them to pass through fully to prices. Our obligation is to keep longer-term inflation expectations well anchored and to make certain that a one-time increase in the price level does not become an ongoing inflation problem.”
One indication of expectations of future cuts in the target for the federal funds rate comes from investors who buy and sell federal funds futures contracts. (We discuss the futures market for federal funds in this blog post.) The data from the futures market indicate that, despite the potential effects of the surprisingly large tariff increases, investors don’t expect that the FOMC will cut its target for the federal funds rate at its May 6–7 meeting. As shown in the following figure, investors assign a 58.4 percent probability to the committee keeping its target unchanged at 4.25 percent to 4.50 percent at that meeting.
It’s a different story if we look at the end of the year. As the following figure shows, investors now expect that by the end of the FOMC’s meeting on December 9-10, the committee will have implemented at least four 0.25 percentage point (25 basis points) cuts in its target range for the federal funds rate. Investors assign a probability of 75.8 percent that the target range will end the year 3.25 percent to 3.50 percent or lower. At their March meeting, FOMC members projected only two 25 basis point cuts this year—but that was before the announcement of the unexpectedly large tariff increases.
Please listen to a podcast discussion recorded just this past Friday between Glenn Hubbard and Tony O’Brien as they discuss tariffs and it’s impact on monetary policy. Also, check out the regular blog posts while on the site! So much has been happening and these posts helps both instructors and students integrate this discussion into their classroom.
Join authors Glenn Hubbard and Tony O’Brien as they discuss the impact of new tariff policies on trade but also on the larger economy. They delve into the Fed, monetary policy, and the impact on inflation. They also discuss some of the history back to when tariffs used to be a high proportion of government revenue and analyze the mix of products that are imported & exported by the US. Should the Fed change its current behavior due to the tariff environment?
Today (March 28), the BEA released monthly data on the personal consumption expenditures (PCE) price index as part of its “Personal Income and Outlays” report. The Fed relies on annual changes in the PCE price index to evaluate whether it’s meeting its 2 percent annual inflation target. The following figure shows PCE inflation (the blue line) and core PCE inflation (the red line)—which excludes energy and food prices—for the period since January 2016 with inflation measured as the percentage change in the PCE from the same month in the previous year. In February, PCE inflation was 2.5 percent, unchanged since January. Core PCE inflation in January was 2.8 percent, up slightly from 2.7 percent in January. Headline PCE inflation was consistent with the forecasts of economists, but core PCE inflation was higher.
The following figure shows PCE inflation and core PCE inflation calculated by compounding the current month’s rate over an entire year. (The figure above shows what is sometimes called 12-month inflation, while this figure shows 1-month inflation.) Measured this way, PCE inflation declined slightly in February to 4.0 percent from 4.1 percent in January. Core PCE inflation jumped in February to 4.5 percent from 3.6 percent in January. So, both 1-month PCE inflation estimates are running well above the Fed’s 2 percent target. The usual caution applies that 1-month inflation figures are volatile (as can be seen in the figure), so we shouldn’t attempt to draw wider conclusions from one month’s data. But it is definitely concerning that 1-month inflation has risen each month since November 2024.
Fed Chair Jerome Powell has noted that inflation in non-market services has been high. Non-market services are services whose prices the BEA imputes rather than measures directly. For instance, the BEA assumes that prices of financial services—such as brokerage fees—vary with the prices of financial assets. So that if stock prices fall, the prices of financial services included in the PCE price index also fall. Powell has argued that these imputed prices “don’t really tell us much about … tightness in the economy. They don’t really reflect that.” The following figure shows 12-month headline inflation (the blue line) and 12-month core inflation (the green line) for market-based PCE. (The BEA explains the market-based PCE measure here.)
Headline market-based PCE inflation was 2.2 percent in February, and core market-based PCE inflation was 2.4 percent. So, both market-based measures show less inflation in February than do the total measures. In the following figure, we look at 1-month inflation using these measures. The 1-month inflation rates are both very high. Headline market-based inflation was 4.0 percent in February, up from 3.5 percent in January. Core market-based inflation was 4.6 percent in February, up from 2.8 percent in January. Both 1-month market-based inflation members have increased each month since November.
In summary, today’s data don’t show any evidence that inflation is returning to the Fed’s 2 percent annual target. It has to concern the Fed that the 1-month inflation measures have been increasing since November with the latest data showing inflation running far above the Fed’s target. The Fed’s goal of a “soft landing”—with inflation returning to the Fed’s 2 percent target without the economy entering a recession—no longer appears to be on the horizon. The current data seem more consistent with a “no landing” scenario in which the economy avoids a recession but inflation doesn’t return to the Fed’s target. As a result, it seems very unlikely that the Fed’s policymaking Federal Open Market Committee (FOMC) will lower its target for the federal funds rate at its next meeting on May 6-7, unless the unemployment rate jumps or the growth of output slows dramatically.
Investors who buy and sell federal funds futures contracts expect that the FOMC will leave its federal funds rate target unchanged at its next meeting. (We discuss the futures market for federal funds in this blog post.) As the following figure shows, investors assign a probability of 82.9 percent to the FOMC leaving its target for the federal funds rate unchanged at the current range of 4.25 percent to 4.50 percent. Investors assign a probability of only 17.1 percent to the FOMC cutting its target by 0.25 percentage point (25 basis points).
As the following figure shows, investors assign a probability of 72.9 percent percent to the FOMC cutting its target range by at least 25 basis points at its meeting on June 17–18. Despite the bad news on inflation in today’s BEA report, investors assign a zero probability to the FOMC increasing its target range for the federal funds rate to help push inflation back to the Fed’s target. One aspect of the current situation that both policymakers and investors are uncertain of is the effect of the Trump Administration’s new tariffs on the price level. It’s possible that some of the increase in inflation seen in today’s report is the result of tariff increases, but the full extent of the effect will only become evident when the tariffs are fully in place.
A tariff is a tax a government imposes on imports. Since the end of World War II, high-income countries have only occasionally used tariffs as an important policy tool. The following figure shows how the average U.S. tariff rate, expressed as a percentage of the value of total imports, has changed in the years since 1790. The ups and downs in tariff rates reflect in part political disa-greements in Congress. Generally speaking, through the early twentieth century, members of Congress who represented areas in the Midwest and Northeast that were home to many manufacturing firms favored high tariffs to protect those industries from foreign competition. Members of Congress from rural areas opposed tariffs, because farmers were primarily exporters who feared that foreign governments would respond to U.S. tariffs by imposing tariffs on U.S. agricultural exports. From the pre-Civil War period until after World War II the Republicans Party generally favored high tariffs and the Democratic Party generally favored low tariffs, reflecting the economic interests of the areas the parties represented in Congress. (Note: Because the tariffs that the Trump Administration will end up imposing are still in flux, the value for 2025 in the figure is only a rough estimate.)
By the end of World War II in 1945, government officials in the United States and Europe were looking for a way to reduce tariffs and revive international trade. To help achieve this goal, they set up the General Agreement on Tariffs and Trade (GATT) in 1948. Countries that joined the GATT agreed not to impose new tariffs or import quotas. In addition, a series of multilateral negotiations, called trade rounds, took place, in which countries agreed to reduce tariffs from the very high levels of the 1930s. The GATT primarily covered trade in goods. A new agreement to cover services and intellectual property, as well as goods, was eventually negotiated, and in January 1995, the GATT was replaced by the World Trade Organization (WTO). In 2025, 166 countries are members of the WTO.
As a result of U.S. participation in the GATT and WTO, the average U.S. tariff rate declined from nearly 20% in the early 1930s to 1.8% in 2018. The first Trump Administration increased tariffs beginning in 2018, raising the average tariff rate to 2.5%. (The Biden Administration continued most of the increases.) In 2025, the second Trump Administration’s substantial increases in tariffs raised the average tariff rate to the highest level since the 1940s.
Until the enactment in 1913 of the 16th Amendment to the U.S. Constitution, which allowed for a federal income tax, tariffs were an important source of revenue to the federal government. As the following figure shows, in the early years of the United States, more than 90% of federal government revenues came from the tariff. As tariff rates declined and federal income and payroll taxes increased, tariffs declined to only 2% of federal government revenue. It’s unclear yet how much tariff’s share of federal government revenue will rise as a result of the Trump Administration’s tariff increases.
The effect of tariff increases on the U.S. economy are complex and depend on the details of which tariffs are increased, by how much they are increased, and whether foreign governments raise their tariffs on U.S. exports in response to U.S. tariff increases. We can analyze some of the effects of tariffs using the basic aggregate demand and aggregate supply model that we discuss in Macroeconomics, Chapter 13 (Economics, Chapter 23). We need to keep in mind in the following discussion that small increases in tariffs rates—such as those enacted in 2018—will likely have only small effects on the economy given that net exports are only about 3% or U.S. GDP.
An increase in tariffs intended to protect domestic industries can cause the aggregate demand curve to shift to the right if consumers switch spending from imports to domestically produced goods, thereby increasing net exports. But this effect can be partially or wholly offset if trading partners retaliate by increasing tariffs on U.S. exports. When Congress passed the Smoot-Hawley Tariff in 1930, which raised tariff rates to historically high levels, retaliation by U.S. trading partners contributed to a sharp decline in U.S. exports during the early 1930s.
International trade can increase a country’s production and income by allowing a country to specialize in the goods and services in which it has a comparative advantage. Tariffs shift a country’s allocation of labor, capital, and other resources away from producing the goods and services it can produce most efficiently and toward producing goods and services that other countries can produce more efficiently. The result of this misallocation of resources is to reduce the productive capacity of the country, shifting the long-run aggregate supply curve (LRAS) to the left.
Tariffs raise the prices of U.S. imports. This effect can be partially offset because tariffs increase the demand for U.S. dollars relative to trading partners’ currencies, increasing the dollar exchange rate. Because a tariff effectively acts as a tax on imports, like other taxes its incidence—the division of the burden of the tax between sellers and buyers—depends partly on the price elasticity of demand and the price elasticity of supply, which vary across the goods and services on which tariffs are imposed. (We discuss the effects of demand and supply elasticity on the incidence of a tax in Microeconomics, Chapter 17, Section 17.3.)
About two-thirds of U.S. imports are raw materials, intermediate goods, or capital goods, all of which are used as inputs by U.S. firms. For example, many cars assembled in the United States contain imported parts. The popular Ford F-Series pickup trucks are assembled in the United States, but more than two-thirds of the parts are imported from other countries. That fact indicates that the automobile industry is one of many U.S. industries that depend on global supply chains that can be disrupted by tariffs. Because tariffs on imported raw materials, parts and other intermediate goods, and capital goods increase the production costs of U.S. firms, tariffs reduce the quantity of goods these firms will produce at any given price. In terms of the aggregate demand and aggregate supply model , a large unexpected increase in tariffs results in an aggregate supply shock to the economy, shifting the short-run aggregate supply curve (SRAS) to the left.
Our thanks to Fernando Quijano for preparing the two figures.
Fed Chair Jerome Powell speaking at a press conference following a meeting of the FOMC (photo from federalreserve.gov)
As they had before their previous meeting, members of the Fed’s Federal Open Market Committee (FOMC) had signaled that the committee was likely to leave its target range for the federal funds rate unchanged at 4.25 percent to 4.50 percent at its meeting today (March 19). In a press conference following the meeting, Fed Chair Jerome Powell noted that the FOMC was facing significant policy uncertainty:
“Looking ahead, the new Administration is in the process of implementing significant policy changes in four distinct areas: trade, immigration, fiscal policy, and regulation…. While there have been recent developments in some of these areas, especially trade policy, uncertainty around the changes and their effects on the economic outlook is high…. We do not need to be in a hurry to adjust our policy stance, and we are well positioned to wait for greater clarity.”
The next scheduled meeting of the FOMC is May 6–7. It seems likely that the committee will also keep its target rate constant at that meeting. Although at his press conference, Powell noted that “Policy is not on a preset course. As the economy evolves, we will adjust our policy stance in a manner that best promotes our maximum employment and price stability goals.” The statement the committee released after the meeting showed that the decision to leave the target rate unchanged was unanimous.
The following figure shows, for the period since January 2010, the upper bound (the blue line) and lower bound (the green line) for the FOMC’s target range for the federal funds rate and the actual values of the federal funds rate (the red line) during that time. Note that the Fed is successful in keeping the value of the federal funds rate in its target range. (We discuss the monetary policy tools the FOMC uses to maintain the federal funds rate in its target range in Macroeconomics, Chapter 15, Section 15.2 (Economics, Chapter 25, Section 25.2).)
After the meeting, the committee also released a “Summary of Economic Projections” (SEP)—as it typically does after its March, June, September, and December meetings. The SEP presents median values of the 18 committee members’ forecasts of key economic variables. The values are summarized in the following table, reproduced from the release.
There are several aspects of these forecasts worth noting:
Committee members reduced their forecast of real GDP growth for 2025 from 2.1 percent in December to 1.7 percent today. Committee members also slightly increased their forecast of the unemployment rate at the end of 2025 from 4.3 percent to 4.4 percent. (The unemployment rate in February was 4.1 percent.)
Committee members now forecast that personal consumption expenditures (PCE) price inflation will be 2.7 percent at the end of 2025. In December, they had forecast that it would 2.5 percent. Similarly, their forecast of core PCE inflation increased from 2.5 percent to 2.8 percent. The committee does not expect that PCE inflation will decline to the Fed’s 2 percent annual target until 2027.
The committee’s forecast of the federal funds rate at the end of 2025 was unchanged at 3.9 percent. The federal funds rate today is 4.33 percent, which indicates that committee members expect to make two 0.25 percentage point (25 basis points) cuts in their target for the federal funds rate this year. Investors are similarly forecasting two 25 basis point cuts.
During his press conference, Powell indicated that a significant part of the increase in goods inflation during the first two months of the year was likely due to tariffs, although the Fed’s staff was unable to make a precise estimate of how much. Economists generally believe that tariffs cause one-time increases in the price level, rather than persistent inflation. Powell was asked during the press conference whether the FOMC was likely to “look through”—that is, not respond—to the tariffs. Powell replied that it was too early to make that decision, but that: “If there’s an inflation that’s going to go away on its own, it’s not the correct response to tighten policy.”
Powell noted that although surveys show that businesses and consumers expect an increase in inflation, over the long run, expectations are that the inflation rate will return to the Fed’s 2 percent annual target. In that sense, Powell said that expectations of inflation remain “well anchored.”
Barring a sharp slowdown in the growth of real GDP, a significant rise in the unemployment rate, or a significant rise in the inflation rate, the FOMC seems likely to leave its target for the federal funds rate unchanged over the next few months.
Today (March 12), the Bureau of Labor Statistics (BLS) released its monthly report on the consumer price index (CPI). The following figure compares headline inflation (the blue line) and core inflation (the green line).
The headline inflation rate, which is measured by the percentage change in the CPI from the same month in the previous year, was 2.8 percent in February—down from 3.0 percent in January.
The core inflation rate,which excludes the prices of food and energy, was 3.1 percent in February—down from 3.3 percent in January.
Both headline inflation and core inflation were slightly below what economists surveyed had expected.
In the following figure, we look at the 1-month inflation rate for headline and core inflation—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year. Calculated as the 1-month inflation rate, headline inflation (the blue line) fell sharply from 5.7 percent in February to 2.6 percent in January. Core inflation (the green line) decreased from 5.5 percent in January to 2.8 percent in January.
Overall, considering 1-month and 12-month inflation together, the most favorable news is the sharp decline in both the headline and the core 1-month inflation rats. But inflation is still running ahead of the Fed’s 2 percent annual inflation target.
Of course, it’s important not to overinterpret the data from a single month. The figure shows that 1-month inflation is particularly volatile. Also note that the Fed uses the personal consumption expenditures (PCE) price index, rather than the CPI, to evaluate whether it is hitting its 2 percent annual inflation target.
There’s been considerable discussion in the media about continuing inflation in grocery prices. In the following figure the blue line shows inflation in the CPI category “food at home,” which is primarily grocery prices. Inflation in grocery prices was 1.8 percent in February and has been below 2 percent every month since November 2023. Although on average grocery price inflation has been low, there have been substantial increases in the prices of some food items. For instance, egg prices—shown by the green line—increased by 96.8 percent in February. But, as the figure shows, egg prices are usually quite volatile month-to-month, even when the country is not dealing with an epidemic of bird flu.
To better estimate the underlying trend in inflation, some economists look at median inflation and trimmed mean inflation.
Median inflation is calculated by economists at the Federal Reserve Bank of Cleveland and Ohio State University. If we listed the inflation rate in each individual good or service in the CPI, median inflation is the inflation rate of the good or service that is in the middle of the list—that is, the inflation rate in the price of the good or service that has an equal number of higher and lower inflation rates.
Trimmed-mean inflation drops the 8 percent of goods and services with the highest inflation rates and the 8 percent of goods and services with the lowest inflation rates.
The following figure shows that 12-month trimmed-mean inflation (the blue line) was 3.1 percent in February, unchanged from January. Twelve-month median inflation (the green line) declined slightly from 3.6 percent in January to 3.5 percent in February.
The following figure shows 1-month trimmed-mean and median inflation. One-month trimmed-mean inflation fell from 5.1 percent in January to 3.3. percent in February. One-month median inflation from 3.9 percent in January to 3.5 percent in February. These data provide confirmation that (1) CPI inflation at this point is likely running higher than a rate that would be consistent with the Fed achieving its inflation target, and (2) inflation slowed somewhat from January to February.
What are the implications of this CPI report for the actions the FOMC may take at its next several meetings? The major stock market indexes rose sharply at the beginning of trading this morning, but then swung back and forth between losses and gains. Inflation being lower than expected may have increased the probability that the FOMC will cut its target for the federal funds rate sooner rather than later. Lower inflation and lower interest rates would be good news for stock prices. But investors still appear to be worried about the extent to which a trade war might both slow economic growth and increase the price level.
Investors who buy and sell federal funds futures contracts still do not expect that the FOMC will cut its target for the federal funds rate at its next two meetings. (We discuss the futures market for federal funds in this blog post.) Today, investors assigned only a 1 percent probability that the Fed’s policymaking Federal Open Market Committee (FOMC) will cut its target from the current 4.25 percent to 4.50 percent range at its meeting next week. Investors assigned a probability of 33.3 percent that the FOMC would cut its target after its meeting on May 6–7. Investors today assigned a probability of 78.6 percent that the committee will cut its target after its meeting on June 17–18. That probability has fallen slightly over the past week.
At his press conference after next Wednesday’s FOMC meeting, Fed Chair Jerome Powell will give his thoughts on the current economic situation.
An image generated by GTP-4o illustrating research.
This opinion column by Glenn appeared in the Financial Times on March 10.
The Trump administration has wisely emphasised raising America’s rate of economic growth. But growth doesn’t just happen. It is the byproduct of innovation both radical (think of the emergence of generative artificial intelligence) and gradual (such as improvements in manufacturing processes or transport). Many economic factors influence innovation, but research and development is key. While this can be privately or publicly funded, the latter can support basic research with spillovers to many companies and applications.
Therein lies the rub: the new administration’s growth agenda is joined by a significant effort to reduce government spending, spearheaded by the so-called Department of Government Efficiency. Some spending restraint can enhance growth by reducing interest rates or reallocating funds towards more investment-oriented activities. But cuts to R&D, as the administration is advocating at the National Institutes of Health (NIH), National Science Foundation (NSF), Department of Energy (DoE) and NASA, are counter-productive. They will limit innovation and growth.
The link between R&D and productivity growth has a long pedigree in economics and has generally been acknowledged by US policymakers. In the mid-1950s, economist Robert Solow made the Nobel Prize-winning conclusion that sustained output growth is not possible without technological progress. Decades later, former World Bank chief economist Paul Romer added another Nobel Prize-winning insight: growth reflected the intentional adoption of new ideas, so could be affected by research incentives.
It is well known that research is undervalued by private companies. Private funders of R&D don’t capture all its benefits. The social returns of R&D are two to four times higher than private returns. These high returns are enabled in the US by federal funding. For example, publicly funded research at the NIH has been found to significantly impact private development of new drugs.
In a comprehensive study, Andrew Fieldhouse and Karel Mertens classify major changes in non-defence R&D funding by the DoE, Nasa, NIH and NSF over the postwar period. They estimate implied returns of as much as 200 per cent — raising US economic output by $2 per dollar of funding. This is substantially higher than recent estimates of returns to private R&D. According to the Congressional Budget Office, the high returns to public funding are more than 10 times that on public investment in infrastructure. With the higher tax revenue generated from additional GDP, an increase in R&D funding more than pays for itself.
In aggregate, productivity gains from federal R&D funding are substantial. Indeed, Fieldhouse and Mertens estimate that government-funded R&D amounts to about one-fifth of productivity growth (measured as output growth less all input growth) in the US since the second world war.
Combined with the high social returns of government-funded R&D, it is essential that policymakers in the current administration acknowledge the risks of underfunding R&D. Spending cuts are clearly harmful to productivity and even budget outcomes.
A shift towards government-financed R&D does not imply that policy in these areas should be beyond review. Some economists have questioned whether current R&D projects take sufficiently high scientific risks, particularly on the ideas of younger scholars. And policymakers can certainly investigate whether indirect cost subsidies to universities and laboratories—in addition to the direct costs of research—are set at the appropriate levels. But, if growth is the objective, the presumption must be that additional public spending on R&D is worthwhile.
Federal support for growth-oriented R&D can extend beyond research grants. Publicly supported applied research centres around the country offer a mechanism to collaborate with local universities and business networks to disseminate ideas to practice. This builds upon the agricultural and manufacturing extension services instituted by 19th-century land-grant colleges that enhanced productivity.
The Trump administration is right to promote growth as a public objective. Spending restraint and fiscal discipline can be growth-enhancing. But all spending is equal. Government-funded R&D is vitally important for innovation and productivity growth. The case is clear.
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