Why the Fed isn’t cutting rates despite cool inflation

Instead, Fed officials are on track to extend their wait-and-see posture on Wednesday.

Fed officials at their meeting will be assessing how the economy handles the initial months of historically large tariff hikes. The last three months’ inflation readings have been mild. Still, officials are worried over how tariff announcements since March could disrupt what economists refer to as “inflation expectations."

Inflation expectations—or what consumers and businesses think inflation will be in the future—can’t be seen or touched. Researchers conduct surveys or infer them from investors’ bets on future inflation.

Expectations are both very tricky to measure and very important to the Fed. Economic theory suggests they play a crucial role in determining actual inflation.

The thinking goes like this: If retailers expect their costs to be higher tomorrow, they will raise prices today to get ahead of it. Landlords will do the same with rents. If workers expect their living expenses to rise, they’ll bargain for higher pay now.

“If everybody expects inflation to go up, then it goes up. And that’s what the Fed is worried about," said Alan Detmeister, an economist at investment bank UBS.

The opposite can also be true. If households think inflation will be low and stable over time, those expectations are said to be “anchored." Economists have found that anchored expectations can prevent a temporary jump in prices—from, for example, a rapid currency depreciation or an oil shock—from leading to higher inflation.

The upshot: Whether and how much the Fed cuts interest rates this year will rest in part on how officials view the risks to inflation expectations.

For consumers, this debate isn’t academic. If the Fed keeps rates higher for longer, mortgage rates may stay elevated and business investment could slow. But if the Fed cuts rates and consumers and businesses have more cushion to tolerate price increases, even more painful rate hikes could be necessary later to wring out inflation.

The recent outlook on expectations is murky. One widely watched measure—a monthly survey by the University of Michigan—showed an unusual jump this spring in both short- and long-term inflation expectations, though it partially reversed after some of the larger tariff hikes were suspended. A separate New York Fed consumer survey has shown only a mild increase.

Measures of market-based inflation expectations show investors expect slightly higher inflation over the next year or two, but not after that.

Some economists find recent increases in inflation expectations concerning because they suggest businesses, having gained the familiarity of boosting profits by hiking prices during the recent period of high inflation, will again test consumers’ willingness to tolerate price increases this summer.

“The Fed is right to sit on its hands and do nothing here. The Fed should be uncomfortable with any of the increase in inflation expectations that some of the surveys have shown," said Ray Farris, chief economist at Eastspring Investments in Singapore.

A worry is that inflation concerns tend to be binary. People can’t simply toggle off their sensitivity after the surge in prices between 2021 and 2023.

Consumers don’t think inflation has “been vanquished in the way that many economists would argue it has been, and that just says to me there’s a greater willingness to accept that prices are going up," Farris said.

Fed officials are worried that inflation expectations could be more fragile because inflation has been running above the Fed’s 2% target for more than four years.

New York Fed President John Williams warned in a talk last month against taking stable expectations for granted. “The past five years have, I think, changed people’s perceptions of inflation, what can happen," he said.

Before the pandemic, people under 40, including his adult children, expected lower inflation than older people did because “they basically had never seen inflation," Williams said. Today, data show expectations are now the same across age groups.

Until the recent episode, current Fed officials also had no firsthand experience managing through a period of high inflation. The last time this kind of rapidly accelerating inflation ended was when policymakers like Williams graduated from college.

Officials think their recent success bringing inflation down with little economic harm occurred partly because the public didn’t anticipate inflation would stay high. By contrast, it took a painful recession in the early 1980s to break the back of a decade of high inflation in the 1970s.

“The lesson from this is, history matters," Williams said. The very low inflation in the U.S. and other advanced economies for decades before the pandemic was “hugely influential in how people formed their inflation expectations during the pandemic—and hugely helpful."

The fluid rollout of the Trump administration’s tariffs is making the current situation more complex. “The textbook notion about tariffs is that…the tariffs get applied once, and everybody understands what they are," Atlanta Fed President Raphael Bostic told reporters this month. “That’s not the environment we’ve had."

Bostic worries that when there are tariff discussions “week after week, month after month, it has the potential to create a psychological response."

Fed governor Christopher Waller is on the other side of the debate. He expects tariffs will generate a one-time increase in prices that won’t fundamentally give businesses greater ability to keep raising prices.

He acknowledged that this sounded like a recipe for repeating the Fed’s mistakes from 2021, when officials judged a broad-based increase in prices following the economy’s reopening from the pandemic would be “transitory." Inflation turned out to be much more persistent.

“Am I playing with fire by taking this position again? It sure looks like it," Waller said in a speech this month.

But he said the current situation is different. For one, the economy faces fewer imbalances. Goods prices could rise later this year, but housing and labor markets aren’t overheated as they were then.

In addition, the economy isn’t benefiting from ultralow interest rates or generous fiscal stimulus. And despite recent success with price increases, businesses know they risk losing market share if inflation-fatigued consumers shop elsewhere or cut back.

Waller doesn’t put much stock in consumer surveys. Even if they’re reliable and households think prices will go up a lot this year, he doesn’t see how people can act on those worries because the labor market isn’t strong enough for workers to secure big raises.

Workers “are probably more worried about keeping their jobs right now," he said. This makes it harder to see the “second-round burst" of inflation that keeps central bankers up at night.

Economists expecting slower growth agree that job-market weakness will short-circuit inflation. “Businesses will be forced to find ways to offset higher input costs," including by laying off workers, said Gregory Daco, chief economist at consulting firm EY.

The Fed doesn’t want to make a mistake. In juggling any trade-offs, it has to wrestle with two important considerations: whether a rise in inflation expectations or a sputtering labor market is more likely, and which is more costly.