By Howard Schneider
ST. LOUIS (Reuters) – U.S. economic growth will likely slip “materially” below trend and the unemployment rate will rise over the year as firms and households adjust to prices driven higher by new import tariffs, St. Louis Fed President Alberto Musalem said.
“I don’t have a baseline of recession,” Musalem said in an interview with Reuters, but “I’m thinking growth is probably going to come in materially below trend,” which he estimated at around 2%.
“You’re getting risk on both sides materializing,” with higher-than-anticipated tariffs putting pressure on prices as declining confidence, a blow to household wealth from the recent sharp drop in equity markets that could depress spending, and the impact of higher prices, all combining to slow growth, Musalem said.
How monetary policy responds will depend on how inflation and unemployment evolve in coming months, whether the price shock appears to be persistent, and whether inflation expectations remain consistent with the Fed’s 2% inflation target, said Musalem, a voter this year on interest rate policy.
He called anchored expectations “a necessary, but not sufficient condition” for the Fed to reach its 2% inflation target.
“We have…tension now between our two objectives going forward,” Musalem said, referring to the Fed’s goals of keeping unemployment low and inflation stable. “My own posture is going to be very vigilant going forward about those two types of risks,” and maintaining a “balanced approach” as long as inflation expectations don’t threaten to rise.
Higher prices from tariffs could lead to a one-time price shock that the Fed could largely look through in setting policy, though Musalem said he regarded that approach as “risky.” Likewise changes in financial conditions and household wealth matter more the longer they are sustained, with the possibility still out there that high tariffs may be negotiated lower over time and markets recover.
But Fed officials are becoming more concerned that the expected price increases from the tariffs as announced, along with retaliation by other nations, could potentially translate into more persistent inflation that would require tighter monetary policy; slowing growth, on the other hand, could possibly raise unemployment, a situation the Fed would otherwise want to counter with easier monetary conditions.
That situation, potentially forcing a choice about which goal to emphasize at the expense of the other, is among the more challenging for central banks, a point policymakers including Fed chair Jerome Powell have been highlighting in recent remarks and particularly since President Donald Trump on April 2 unveiled tariffs beyond what investors and Fed officials anticipated.
“I’m seeing a high degree of uncertainty…I’m seeing low and declining confidence by households and businesses. I’m seeing the actual impact of tariffs now will raise prices that will lower real incomes of people and of businesses, and I’m also seeing retaliation from some trading partners,” Musalem said. “All of those suggest downside to growth, on the upside to inflation.”
On recent market volatility, including the sharp selloff in equity prices and increases in some credit spreads, Musalem said he was watching a broad set of financial market indicators and feels that financial conditions have tightened.
But Fed policymakers typically distinguish between the sometimes sharp changes that occur in financial markets and events that can cause markets to seize altogether.
So far he said he views recent equity and credit dynamics “as a response of the market to a repricing of downside growth risks to the global economy.”
“I’m not sensing market dysfunction,” he said. “Yes, volatility has been high. Yes, asset prices…whether it’s currencies, whether it’s fixed income, whether it’s equities, whether it’s corporate credit, whether it’s commodities, all have been moving substantially and erratically. But I don’t sense a market function problem yet.”
The Fed ended 2024 with a broad sense that the central bank was at least close to a “soft landing” from the high inflation of the pandemic years, with the unemployment rate near 4% while inflation had fallen to just about half a percentage point above target and seemed poised to fall more. The Fed’s benchmark interest rate, tightened aggressively when inflation rose in 2021 and 2022, had been cut a full percentage point.
But the outlook has been changing under Trump to one of slower growth, higher inflation, and far more uncertainty, with policymakers left to divine which way the economy might turn before committing to a path for interest rates.
The current benchmark rate between 4.25% to 4.5% is expected to be held steady when the Fed next meets in May, though investors have begun pricing in the likelihood of more aggressive Fed cuts as the stock market has sunk.
One thing that could trigger a Fed response is a clear turn towards rising joblessness after a more than three-year stretch with the economy near or below common estimates of full employment.
Musalem said that business contacts are not yet signaling a turn towards layoffs, but have grown cautious about upcoming hiring and capital investment plans.
“We’re not hearing of layoffs yet. We’re hearing wait and see by companies…in terms of their capital expenditure plans, in terms of their hiring plans,” he said. But “even before the tariffs I had penciled in an unemployment rate, in my own personal forecast, that would be increasing gradually, very gradually, but still consistent with full employment…The risk around that has tilted to the upside.”
(Reporting by Howard Schneider; Editing by Daniel Burns and Anna Driver)
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