"Former Federal Reserve Vice Chair": Stagflation is now the best scenario for the United States

With the Trump administration initiating an unprecedented trade war, the "former third-in-command of the Federal Reserve" warns that stagflation has become the most optimistic scenario for the U.S. economy, while the worst outcome could be a double whammy of inflation and recession.

On Monday local time, former New York Fed President Bill Dudley wrote that Trump's current tariff policies are far more aggressive than during his first term, which will have a significant impact on the U.S. economy. It is expected that within the next six months, the inflation rate in the U.S. may approach 5%, while economic growth this year will plummet to around 1%. Meanwhile, the Federal Reserve is caught in a dilemma—raising interest rates accelerates recession, while lowering rates worsens inflation.

Don't expect the Federal Reserve to save the U.S. economy, as the Trump administration has imposed hefty tariffs on most imported products globally. The only question now is how severe the damage will be.

Trump's Tariffs May Devastate the U.S. Economy

Dudley stated that Trump's tariff policies are far more intense than during his first term, which will cause the U.S. weighted average tariff rate to surge from less than 3% to over 25%. This unprecedented scale of trade impact will push the annualized inflation rate to rebound and approach 5% within the next six months. Not only will the prices of imported goods rise, but domestic producers will also have the incentive to raise prices in an environment with reduced competitive pressure.

At the same time, the demand side will face severe blows. Dudley noted that corporate investment will be delayed due to the uncertainty of tariff policies, and household spending will shrink due to a tax increase equivalent to $600 billion. Even if Congress passes tax cuts to offset the impact of tariffs, the lagging issue and income distribution imbalance—where low-income families are hit harder by tariffs but benefit less from tax cuts—will lead to a comprehensive decline in demand.

More worryingly, the long-term growth potential of the U.S. economy is being systematically weakened. The expulsion of illegal immigrants and tightening immigration policies will lead to a labor supply shortage, while the tariff impact will suppress productivity improvements. In this scenario, Dudley predicts that the sustainable real output growth rate of the U.S. economy may drop from last year's 2.5%-3% to around 1%.

Considering these factors, stagflation has become the most optimistic scenario, while a more likely outcome is that the U.S. economy falls into recession while inflation continues to rise.

The Federal Reserve's Dilemma: The Dual Shackles of Inflation and Recession

Investors expect the Federal Reserve to provide "insurance-style" rate cuts to support the economy as it did in 2019, but Dudley points out that this expectation is overly optimistic, and there are ample reasons to question whether this condition can be met:

First, inflation has been above the Federal Reserve's 2% target for several consecutive years. If this year becomes the fifth year of exceeding inflation and accelerates upward, the risk of inflation expectations becoming unanchored significantly increases.

Second, the tariff impact is similar to the oil crisis of the 1970s, and such supply-side shocks to productivity typically have lasting effects on inflation. Back then, inflation was only controlled after Volcker pushed short-term interest rates to nearly 20%, forcing the economy into a deep recession.

Third, the Federal Reserve's own actions influence the formation of expectations. If the market believes the Federal Reserve is ignoring inflation pressures while overly focusing on growth, this perception itself will lead to rising inflation expectations The market currently expects interest rate cuts of more than 100 basis points this year, but Dudley believes that such a level of cuts is only likely to occur if the economy actually enters a recession. Unlike the environment in 2019 where inflation was below target, the current flexibility of the Federal Reserve's policy has been significantly reduced