What can the Federal Reserve do when Trump wants to "detox" the U.S. economy?

With the growth of the U.S. economy and the emergence of downward risks in the labor market, the market currently presents a "dual peak" expectation for the Federal Reserve: either the economy remains resilient, with persistent high inflation prompting the Fed to maintain its current policy stance; or government job cuts and uncertainty in trade policy lead to a freeze in private sector hiring, resulting in a sharp deterioration of the labor market, which would necessitate a steeper rate-cutting path.

On March 10, Deutsche Bank analysts Matthew Luzzetti, Brett Ryan, Justin Weidner, and others released a research report analyzing the current market policy expectations in depth, stating that "the dovish considerations are very compelling." Deutsche Bank's baseline forecast is that the Federal Reserve will keep interest rates unchanged this year, but also acknowledges that "the downward risks facing the economy are increasing, which may require the Fed to cut rates this year."

Hawkish Considerations: Inflation Pressure May Persist

Deutsche Bank points out several reasons from a hawkish perspective for the Fed to maintain its policy stance.

First, the U.S. economy was in good condition before entering this phase, with leading indicators (credit and financial conditions, CEO/CFO confidence, and other business surveys) showing an upward trend. The Fed's long-term policy statement indicates that when the labor market is at or above target levels, and inflation remains significantly above target, a certain degree of cooling in the labor market should be accepted to bring inflation back to target.

More importantly, real-time identification of tariff-induced inflation is very difficult:

"Steel and aluminum tariffs may raise new car prices, subsequently increasing auto repair inflation, which in turn raises core services inflation, further pushing up auto insurance inflation. This complex transmission chain makes it difficult for the Fed to distinguish between tariff-driven and organic price pressures."

Inflation expectations may also no longer be firmly anchored. Deutsche Bank's Composite Inflation Expectations (CIE) index is at its highest level since the end of 2023 and is above any level seen before the pandemic since 2008. Recent Fed research shows that higher short-term inflation expectations may increase wage pressures and extend the impact of tariffs on prices.

In other words, in the context of high inflation and accelerating price increases, the Fed should be cautious about how inflation expectations respond to rate cuts.

Dovish Factors: Uncertainty and Market Fragility

On the other hand, from a dovish perspective, policy uncertainty may create a paralyzing effect. The Trump administration is implementing negative growth policies, having cut tens of thousands of federal government jobs, with a goal of ultimately reducing by 10%. Uncertainty in government funding may lead non-profit organizations, government contractors, and private entities reliant on government funding to freeze hiring and spending. Record-high trade policy uncertainty may cause corporate capital expenditures and labor decisions to be put on hold.

At the same time, the labor market may exhibit nonlinear dynamics. The Sahm rule indicates that once the unemployment rate begins to rise, it may trigger a negative feedback loop of reduced consumer spending and further layoffs, especially in the context of federal government spending cuts, making it more difficult to contain this cycleOn the tariff front, those with a dovish view believe that tariffs represent adverse supply shocks, which will push up inflation and reduce growth. However, in the absence of higher inflation expectations, the second-order effects of this policy should limit the rise in inflation over time.

The research report points out that the market has interpreted these developments as a significant increase in the risk of a U.S. economic recession this year. The stock market has fallen about 8% from recent highs, credit spreads remain tight but have begun to widen, and the Federal Reserve's one-year Financial Conditions Index (FCI-G) is approaching neutral for the first time since the end of 2023. Therefore:

"Looser policies may be needed to alleviate the tightening of the Financial Conditions Index (FCI). While we are not yet close to a critical point, if the government does not adjust its policy plans in response to market volatility, the Federal Reserve may become the last policy lever capable of preventing more destructive fluctuations in the financial markets, which could threaten the economic growth outlook."

Although market expectations for the Federal Reserve's policy path remain relatively mild, New York Fed President Williams recently stated that the market is pricing in one rate cut this year, but current average pricing indicates a rate cut of about 75 basis points in 2025.

Risk Warning and Disclaimer

The market has risks, and investment should be cautious. This article does not constitute personal investment advice and does not take into account the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. Investing based on this is at your own risk