The Federal Reserve falls into the "Trump dilemma"

Former New York Fed board member and Vice Chairman of Evercore ISI, Krishna Guha, stated that the U.S. election has put the Federal Reserve in a dilemma, and the current economic forecast summary of the Federal Reserve is actually a "constrained Harris election prospect," with Trump being a disruptor. Here are his views.

Investors are trying to understand what Trump's potential re-election means for the U.S. economy, the Federal Reserve, and interest rates, while also weighing the possibility of Vice President Harris reversing the situation.

Trump urges the Federal Reserve not to cut interest rates quickly while inflation remains high, with many interpreting this as meaning that a rate cut before the November election is unreasonable. Although this will not prevent the Fed from cutting rates in September, it becomes more important for the Fed to systematically articulate its reasons, which is also one of the reasons why this week's meeting is unlikely to cut rates early.

Most investors assume that once Trump is re-elected, he will pressure the Federal Reserve to cut rates . Intense "verbal intervention" seems possible, although direct attacks on the Fed's independence proposed by some Trump advisors are unlikely to materialize, and if they do, they may be quickly stopped due to a surge in bond yields and selling in the stock market.

Any political pressure will make it more difficult for the Fed to maintain credibility while cutting rates. Fed Chair Powell may keep a low profile, focus on his work, and rely on Congress to provide protection from the executive branch. However, the Fed still needs to consider the potential impact of Trump's policies.

The current economic forecast summary of the Federal Reserve is actually a "constrained Harris election prospect" . This is because the forecast assumes no new shocks, a scenario that is likely to occur if Harris wins but is constrained by a Republican-controlled Senate. But Trump is a disruptor. Changes in market prices indicate that investors believe Trump's trade, immigration, fiscal, energy, and deregulation policies overall have re-inflation effects, pushing up nominal GDP and inflation.

This poses a dilemma for the Federal Reserve: should it update its policy plans based on expected shocks as soon as possible, or wait and risk falling behind changing circumstances? It seems likely to make mistakes in slowly adapting to potential shocks, that is, updating its baseline forecast after the election and then proceeding cautiously.

The Fed does not know who will win the election, nor does it have an advantage in judging which policies will be implemented, and it is acutely aware of the difficulty of simulating potential impacts. It will not want to anticipate inflationary effects of Trump's policies during the campaign. Fortunately, bond yields are helping to alleviate some of the burden, as the likelihood of Trump's victory increases, bond yields will also rise, helping to prevent the economy from overheating.

While the Fed must consider the potential increase in tariffs, reduced immigration leading to a decrease in labor supply, and the possibility that loose fiscal policy will generate more persistent inflationary pressures, some of Trump's shocks, especially tariffs, are theoretically one-time price level shocks rather than sustained inflationary pressures. In the short term, the Federal Reserve has sufficient reason to closely monitor the upcoming inflation and employment data. However, it would be unwise if it completely ignores obvious potential significant impacts.

The Federal Reserve should not alter its baseline view based on predictions of who will win the election, it should consider what level of interest rates would position it favorably by mid-2025 to deal with various scenarios. These scenarios should include potential impacts led by Trump, potential impacts of a constrained president Harris. Then, it should gently sketch out an interest rate path consistent with this.

Based on current information, being in a good position by mid-2025 may mean interest rates between 4% and 4.5%, a range significantly lower than the current 5.25% to 5.5% range, but still somewhat restrictive.

If the impact is inflationary or if inflation is somewhat sticky, the Fed can pause action, even raising rates by the end of 2025 if necessary. If the impact and data are not inflationary, it can continue to cut rates, even accelerating the pace. If we expect two rate cuts in the first half of 2025, this leaves room for two, or even possibly three rate cuts in the remaining time of 2024.

Of course, no policy path can remain unchanged. If the labor market significantly deteriorates in the coming months, the Fed will need to take decisive action. The focus will then shift to ensuring a soft landing and later worrying about possible Trump impacts