A key question looms over the Federal Reserve as President Trump contemplates bolder uses for tariffs in his second term: How much would any price increases fuel expectations of higher inflation by the broader public?
The Fed is widely expected to hold its benchmark interest rate steady at its two-day meeting that concludes Wednesday, taking a pause after cutting short-term rates by a full percentage point at its last three meetings.
Since officials first cut rates in September , inflation has made uneven progress toward the central bank’s 2% goal. The labor market, meanwhile, has expanded steadily , dousing fears of a sudden weakening that flared last summer.
When or whether the Fed resumes cuts rests in large part on the outlook for inflation which, in turn, could be shaped this year by whether Trump follows through on threats to raise tariffs. Last week, Trump said he was considering whether to impose higher duties on imports from Canada and Mexico by this Saturday.
Tariffs remain a key wild card for the Fed’s outlook because of concerns over how they could influence businesses’ and consumers’ expectations of future inflation.
To be sure, the Fed ended up lowering rates in 2019 when Trump escalated a trade war the first time he was president. Fed Chair Jerome Powell and his colleagues feared the hit to business sentiment and investment from a trade war might swamp potential effects of higher prices from tariffs.
Those tariffs were relatively small. To the extent they influenced economic activity, “they were not inflationary because that was not an inflationary period,” said Steven Kamin, who at the time oversaw the Fed’s international finance division and is now at the American Enterprise Institute.
The Fed is likely to react differently this time around after any tariff increases take effect because the U.S. has just been through a period of great inflation.
“Price setters and price payers are much more attuned to price pressures than they were back in 2018,” said Kamin. He said he expects the Fed “to indeed lean against tariff hikes much more in this round than the last” by holding interest rates higher than they would otherwise if tariff increases are enacted.
Because the Fed hardly ever changes interest rates based on policy outcomes that haven’t happened, the Fed is unlikely to react until tariff increases materialize, Kamin said.
Fed officials closely monitor inflation expectations, captured from both consumer surveys and market-based measures, because “if people expect inflation to be higher, they will respond and react differently, in a way that will drive more inflation,” said Cleveland Fed President Beth Hammack in an interview this month .
For example, if landlords expect their costs to go up in the future, they will raise rents to get ahead of cost increases. Workers will negotiate for higher raises.
A survey of consumers by the University of Michigan released last week showed inflation expectations have edged up since November’s election. Researchers who conducted the survey said consumers continued to spontaneously express that they were buying cars and other durable goods now to avoid future price increases.
Investors’ expectations of inflation one and two years ahead have ticked up over the past few months, even though longer-run expectations are little changed, according to measures such as the two-year inflation break-even rate.
The last time Trump was president and imposed tariffs on trading partners, expectations of future inflation were low and firmly anchored—or set in dry cement. The public had little experience with inflation, and that made businesses more hesitant to pass along price increases from tariffs.
“They didn’t know how much business they would be losing” if they raised prices, said Hammack.
But several years of high inflation triggered by the pandemic and a policy response that showered the economy with ultralow interest rates and fiscal stimulus have raised questions over whether the Fed could be as relaxed about an increase in prices. If the cement is wet, expectations of higher inflation in the future could sustain higher price growth.
Because corporate management teams have been passing through higher costs, they have the experience of raising prices that they lacked five years ago. Even domestic producers that aren’t hit by tariffs could use higher import prices as an excuse for raising their own prices.
“There’s more acceptance of prices going up because of what we’ve lived through,” said Hammack.
Scott Bessent, who was confirmed Monday as Trump’s Treasury secretary, played down the prospects of higher consumer prices from tariffs at his confirmation hearing earlier this month. He said the dollar could strengthen against foreign currencies, offsetting part of the increased cost to U.S. importers, while foreign manufacturers could cut prices and consumers could shift their purchases to avoid any remaining cost increase.
The centrality of expectations in the Fed’s view of the inflation-generating process means that how tariff increases are implemented could matter for how officials set interest rates.
In 2018, Kamin and other Fed economists modeled the impact of a tariff increase and concluded the central bank could look through—or not react to—higher inflation readings so long as two conditions held: Households and businesses expected inflation to stay low, and the price increases flowed through the economy quickly.
“If you did them all at once and never did them again, they would just be a one-time jump in the price level. You’d see a spike in inflation and then it would kind of go away,” said Fed governor Christopher Waller during a question-and-answer session at a conference in Europe earlier this month.
But if tariff increases are applied at different times to different countries and on varying goods, it could be harder for the Fed to tease out whether prices are rising because of tariffs or whether broader macroeconomic forces were responsible.
“Will it be a ‘one-and-done’ or will it be two years of a sequence of tariffs in many different sectors of the economy?” St. Louis Fed President Alberto Musalem said in an interview this month. “If it’s over two years, incrementally, every month or every two months, it gets harder to parse out.”
To understand why Fed officials are so nervous about compromising the stability of inflation expectations, it helps to look at projections they made in December.
At their last meeting, officials projected that underlying inflation would continue to decline to 2%, from around 2.8% at the end of last year, over the next two years despite steady economic activity and little slack—such as unemployed workers and idled factories—in the economy.
Fed models say that with long-run inflation expectations anchored at a low level, “that will have a gravitational effect on inflation as people are setting wages and prices, and that will be enough to pull actual inflation down to 2%,” said William English, a former senior Fed adviser.
A risk for the Fed is that, “in practice, it doesn’t really work,” said English, a professor at Yale School of Management. If inflation hangs out closer to 3% than to 2%, Fed officials are likely to conclude they need to hold rates at a high level for long enough to create more weakness in the economy to bring prices down.
Write to Nick Timiraos at Nick.Timiraos@wsj.com