The case for rate cuts is growing

President Trump’s tariffs present the Federal Reserve with two conflicting challenges. First, they raise prices, which weakens the case for cutting interest rates. Second, they sap confidence and demand, which strengthens the case.

To date, the Fed has focused on the first risk, keeping its interest rate target between 4.25% and 4.5% since December. It might soon have to pivot to the second. Evidence is accumulating that inflation, despite tariffs, has been milder than feared, while the labor market might be deteriorating.

The Fed doesn’t have to act when it meets next week. There is less urgency than last September when rates were a full percentage point higher and rising unemployment carried a whiff of recession. Tariff effects might become more pronounced in coming months.

But in their outlook and rhetoric, Fed officials need to acknowledge risks are shifting. And they can also pat themselves on the back, because the economy is actually unfolding much as they expected when they began easing nine months ago.

Where are the tariffs?

In May, the Treasury Department collected roughly $15 billion more in customs duties than in February. That is equal to about 3% of total consumer spending on goods. Some goods prices have risen, but not by that much. And in May, prices on some obvious tariff targets like apparel and new cars fell.

This is a head scratcher. If consumers aren’t paying the tariffs, who is? Not foreign producers, at least through April, when import prices excluding fuel rose. Not, apparently, retailers and wholesalers, whose margins took a hit in April but bounced back in May, according to the producer price report released Thursday.

Maybe the data isn’t picking up some of the ways companies are coping with tariffs, such as keeping prices stable but charging more for shipping. In any case, the Fed ought to take comfort that the supply chain has proved much more resilient than a few years ago.

The trend is the Fed’s best friend

Economists think tariff effects will become more apparent in coming months. But that alone isn’t reason enough for the Fed to stay on hold. Tariffs represent a one-time boost to the price level, which means after a year inflation should revert to its pre-tariff trend. The question is whether tariffs push the trend higher.

The good news is that in the last few months the trend has eased. A key reason inflation has been slow to return to the Fed’s 2% target is stubborn service prices, and that can in great part be blamed on housing costs cooling more slowly than economists and the Fed expected based on private rent data.

Not any more. “A lot of what we expected in shelter has come to fruition," said Omair Sharif, an independent forecaster specializing in inflation data.

Services inflation has also been damped by plunging airfares, thanks to more empty seats and cheaper jet fuel.

Interest rates remain about 0.5 to 1.5 percentage points above what the Fed considers “neutral," the level that keeps growth, inflation and unemployment stable.

Together, this is why excluding energy, services inflation fell to 3.5% in May, from 4.5% in December, which in turn has nudged core inflation (which excludes food and energy) to a four-year low of 2.8% in the last three months. Inflation according to the Fed’s preferred gauge, the price index of personal consumption expenditures, is also near its lowest since the pandemic, likely between 2.5% and 2.6% in May. It is running at around 1.3% annualized in the last three months. But for tariffs, the Fed would probably declare mission accomplished by year-end.

The labor market looks shaky

So the underlying trend suggests the Fed should be easing. Now suppose tariffs do lift core inflation in coming months. For that to push the underlying trend higher depends crucially on the labor market. The pandemic inflation was so persistent because it occurred when workers were so scarce. Demand was strong, and people had left the labor force because of Covid or retirement. Wage inflation shot from 3.5% before the pandemic to 7%.

The labor market today isn’t tight; it’s showing cracks. The unemployment rate, to two decimal places, has risen every month since January, by a quarter percentage point in all. At that pace it would reach 4.6% in the fourth quarter. This suggests the economy is growing slightly below its potential, which should keep a lid on price and wage pressures.

An important reason inflation has been slow to return to the Fed’s 2% target is stubborn service prices.

For months, both hiring and layoffs have been low, keeping unemployment under wraps. But new claims for jobless insurance jumped in the last two weeks, a hint that layoffs—outside the federal government—are picking up.

Payroll growth looks healthy, at 139,000 in May. This, though, could be a head fake. From January through April. the Bureau of Labor Statistics initially reported hefty job growth only to revise that down sharply in later months. The same could happen with May data.

RBC Capital Markets recently noted that a string of negative revisions like this is common around recessions. Another hint: payroll processor ADP estimates that, based on a survey of its clients, private job growth was just 34,000 in May.

Why the labor market would weaken is unclear. Stock prices are buoyant, not what you’d see right before a recession. Perhaps uncertainty about tariffs is undercutting hiring, although that link isn’t obvious. And Republicans’ tax-and-spending bill could deliver fiscal stimulus later this year.

Against that, though, tariffs are already draining money from the economy. And if they do push inflation higher in coming months, they will also cut into purchasing power, aggravating risks to jobs.

Though not as out of whack as last September, rates are still roughly 0.5 to 1.5 percentage points above what Fed officials consider “neutral," the level that keeps growth, inflation and unemployment stable. That restrictive stance make sense so long as inflation is all the Fed has to worry about. It no longer is.

Write to Greg Ip at greg.ip@wsj.com