To cut or not to cut? US Fed faces stubborn inflation and weak growth

Euronews

17-03-2025

When Federal Reserve officials last met in late January, things looked pretty good. Hiring was solid, the economy had just grown at a solid pace in last year's final quarter. Inflation, while stubborn, had fallen sharply from its peak more than two years ago.
What a difference seven weeks makes.
As the Fed prepares to meet on Tuesday and Wednesday, the central bank and its chair, Jerome Powell, are potentially headed to a much tougher spot. Inflation improved last month but is still high and tariffs could push it higher. At the same time, ongoing tariff threats as well as sharp cuts to government spending and jobs have tanked consumer and business confidence, which could weigh on the economy and even push up unemployment.
The toxic combination of still-high inflation and a weak or stagnant economy is often referred to as "stagflation," a term that haunts central bankers. It is what bedevilled the United States in the 1970s, when even deep recessions didn't kill inflation.
Stagflation, should it emerge, is hard for the Fed because typically policymakers would lift rates — or keep them high — to combat inflation. Yet if unemployment also rises, the Fed would usually cut rates to reduce borrowing costs and lift growth.
It's not yet clear the economy will sink into stagflation. For now, like businesses and consumers, the Fed is grappling with a huge amount of uncertainty surrounding the economic outlook. But even a mild version — with unemployment rising from its current low level of 4.1%, while inflation stayed stuck above the Fed's 2% target — would pose a challenge for the central bank.
"That's the tangled web they're in," Esther George, former president of the Federal Reserve's Kansas City branch, said. "You have inflation stickiness on the one hand. At the same time, you're trying to look at what impact could this have on the job market, if growth begins to pull back. So it is a tough scenario for them for sure."
Fed officials will almost certainly keep their key rate unchanged at their meeting this week. Once the meeting concludes Wednesday, they will release their latest quarterly economic projections, which will likely show they expect to cut their rate twice this year — the same as they projected in December.
The Fed implemented three cuts last year and then signalled at the January meeting that they were largely on pause until the economic outlook becomes clearer.
Wall Street investors expect three rate reductions this year, in June, September, and December, according to futures prices tracked by CME Fedwatch, in part because they worry an economic slowdown will force more reductions.
One development likely to unnerve Fed officials is the sharp jump in inflation expectations this month in the University of Michigan's consumer sentiment survey. It showed the biggest increase in long-term inflation expectations since 1993.
Such expectations — which measure whether Americans are worried inflation will get worse — are important because they can become self-fulfilling. If businesses and consumers expect higher costs, they may take steps that push up inflation, like demanding higher wages, which in turn can force companies to raise prices to offset higher labour costs.
Some economists caution that the University of Michigan's survey is preliminary and for now based on only about 400 responses. The final version to be released later this month typically includes about 800. Added to this, financial market measures of inflation expectations, based on bond prices, have declined in recent weeks.
The most recent inflation readings have been mixed. The consumer price index dropped last week for the first time in five months to 2.8% from 3%, an encouraging change. But the Fed's preferred price gauge, to be released later this month, is likely to be unchanged.
The jump in inflation expectations is also a problem for the Fed because officials, including Powell, have said they are willing to let inflation gradually return to their 2% target in 2027, because expectations have generally been low. If other measures show inflation worries rising, the Fed could come under more pressure to get inflation down more quickly.
"I do worry when I see consumer expectations moving in the opposite direction," George said.
"I think you just have to keep an eye on that."
The last time President Donald Trump imposed tariffs — in 2018 and 2019 — overall inflation didn't rise by much, in part because they weren't nearly as broad as what he is currently proposing and some duties, such as those on steel and aluminium, were watered down with loopholes. Now that Americans have lived through a painful inflationary episode, they are likely to be more skittish about rising prices.
Powell referred to such concerns in remarks earlier this month. He said tariffs could just have a one-time impact on prices without causing ongoing inflation. But that could change "if it turns into a series" of tariff hikes, he said on 7 March, or "if the increases are larger, that would matter".
"What really does matter is what is happening with long-term inflation expectations," Powell added.
A week after his comments, those expectations shot higher in the University of Michigan survey.
Europe's economy is set for a weaker-than-expected recovery as trade disruptions and persistent inflation weigh on sentiment, according to the Organization for Economic Co-operation and Development (OECD).
The Paris-based institution has cut its eurozone gross domestic product growth forecast to 1.0% for 2025, down from 1.3% in its December projections.
The downgrade reflects slowing investment and subdued consumer confidence amid mounting geopolitical and trade risks. Meanwhile, global growth is also expected to weaken, with the OECD cutting its forecast by 0.2 percentage points to 3.1%.
The revised projections were published on Monday in the OECD Economic Outlook, Interim Report March 2025, which warns that global growth is slowing amid rising trade tensions and lingering inflationary pressures. The report highlights a fragile recovery in Europe and significant risks stemming from economic fragmentation.
The eurozone's projected 1.0% expansion in 2025 marks a 0.3 percentage point downgrade from December's forecast. Germany, the bloc's largest economy, faces the sharpest revisions, with GDP now expected to grow just 0.4% in 2025, down from 0.7% previously.
The OECD noted that 'heightened uncertainty keeps growth subdued' across the euro area. For 2026, eurozone growth has also been downwardly revised by 0.3 percentage points to 1.2%.
According to the OECD, the broader euro area continues to struggle with weak external demand and elevated borrowing costs, limiting the potential for a strong rebound.
France and Italy also saw slight downward adjustments to 0.8% and 0.7%, respectively.
Spain remains a relative bright spot, with growth forecast at 2.6% for 2025 and at 2.2% for 2026, slightly above prior estimates.
The OECD warns that escalating trade barriers and geopolitical uncertainty could further weaken global growth.
'Further fragmentation of the global economy is a key concern,' the report stated, adding that 'higher and broader increases in trade barriers would hit growth around the world and add to inflation'.
If trade restrictions continue to spread, global GDP could fall by 0.3% over the next three years, while inflation could rise by 0.4 percentage points annually.
The OECD's latest projections also reflect the economic fallout from newly imposed US trade tariffs under Donald Trump's administration.
Mexico and Canada have faced the largest downward revisions, with Mexico's 2025 GDP now expected to shrink by 1.3%—a 2.5 percentage point cut from December's estimate.
Canada's growth outlook has been slashed by 1.3 percentage points to just 0.7%.
The US economy has also seen its forecast cut. GDP is now expected to grow by 2.2% in 2025, down 0.2 percentage points from December.
The OECD said that the 'negative impacts are projected to be particularly severe in Canada and Mexico' due to their high trade exposure to the United States.
Inflation remains a persistent challenge. While price growth has slowed from its 2022 peaks, headline inflation in the eurozone is expected to remain at 2.2% in 2025 before easing to 2.0% in 2026.
Services inflation continues to exert pressure, with the OECD noting that 'services inflation is still elevated, with labour markets tight, and goods inflation is picking up from very low levels'.
In the United Kingdom, inflation is expected to stay higher for longer, averaging 2.7% this year before declining to 2.3% in 2026. In the United States, the OECD noted that 'core inflation is now projected to remain above central bank targets' in 2026, with inflation expected at 2.8% in 2025.
With inflation still above target, central banks are unlikely to cut rates aggressively. The OECD expects the European Central Bank (ECB) to lower rates gradually, with its key policy rate projected to fall to 2% by late 2025. The Bank of England is also expected to reduce rates but at a measured pace.
The US Federal Reserve, however, 'is projected to remain unchanged until well into 2026 in the baseline projection'. Meanwhile, Japan is expected to continue its slow exit from ultra-loose monetary policy.
The OECD stresses that greater international cooperation is needed to avoid further economic fragmentation.
'Countries need to find ways of addressing their concerns together within the global trading system,' the report said, adding that 'living standards would benefit from coupling these measures with efforts to strengthen the resilience of supply chains'.
Structural reforms will also be crucial in boosting long-term growth, particularly in Europe. The OECD calls for measures to enhance productivity, reduce regulatory burdens, and invest in digital infrastructure. The report also highlights that 'faster diffusion of artificial intelligence technologies could also have significant productivity benefits'.
As Europe and the global economy navigate an increasingly uncertain landscape, 'significant risks remain,' the OECD warns. While growth has proven resilient so far, the global economy faces a 'key concern' in the form of rising trade tensions, policy uncertainty, and stubborn inflation.