The Fed’s Pickle

The Federal Reserve System (Fed) has two mandates: maximum employment and stable prices.

Fed policymakers interpret these goals as an annual inflation rate of 2% and the lowest sustainable level of unemployment without pushing wages and prices up. Usually, these two goals are complementary, and the Fed can focus on one at a time.

But that’s not the case right now.

In August, the annual inflation rate measured by the Personal Consumption Expenditures (PCE) Price Index was estimated at 2.8%, marking over four years above the 2% target. Moreover, inflation is expected to increase further in the coming months as businesses pass the costs of tariffs onto consumers by increasing prices.

Simultaneously, the unemployment rate increased last month to 4.3%. Although still low by historic standards, low employment growth (an average of 29,000 jobs added each month over the last three months) and a low hiring rate by businesses means that the unemployment rate is likely to increase further.

What should the Fed do?

Hike interest rates to lower inflation? This inflation episode is likely to be temporary. Although tariffs will increase consumer prices, once they are fully integrated, inflation should return to its pre-tariff rate. However, this return is not guaranteed—in 2021, an increase in prices of goods due to supply chain problems spilled over to prices of other goods and services.

Slash interest rates to spur job growth and the economy in general? An increase in taxes on imported goods, which is exactly what a rise in tariff rates is, will probably erode household purchasing power and might further slow the economy. Given the current environment of weak job growth and slow hiring by companies, such a negative shock could cause a rapid increase in the unemployment rate.

Fed policymakers operate in a world of abundant risks and limited options. Inflation is elevated, but likely transitory. While there is no need to raise rates, the risk of inflation spiraling out of control means that the room for cuts is limited as well. At the same time, the possibility of a further and potentially uncontrolled deterioration of the labor market means that some cuts are nevertheless warranted, which is exactly what the Fed did earlier this month.

It’s an economic pickle that the Fed hopes doesn’t sour even more.