Introduction to the Federal Reserve’s Dilemma
The Federal Reserve is currently facing a difficult decision. With the economy showing signs of slowing down, many experts believe that a quarter-point interest rate cut is necessary to boost economic activity. However, this cut could also lead to increased inflation, which would be detrimental to the economy.
The Case for a Rate Cut
Markets are expecting a rate cut to a range of 4% to 4.25% when the Fed policy-setting committee concludes its latest meeting on September 17, 2025. The slowdown in the jobs market, as well as a massive revision to past figures showing close to a million fewer jobs were created than previously reported, makes a strong case for lower interest rates to shore up the economy. The labor market has seen continued deterioration, with the Bureau of Labor Statistics’ revisions to nonfarm payrolls reducing the number of jobs economists thought the U.S. gained by almost 1 million for the year ending in March 2025.
The Risk of Inflation
But at the same time, inflation has begun to accelerate again. Rising tariffs are squeezing consumer spending in sectors exposed to the harshest tariffs, such as clothing and electronics. The consumer price index has consistently ticked up over the past four months, with the most recent CPI figure indicating year-over-year inflation of 2.9% – well above the Fed’s target of 2%. This makes the Fed’s decision more complicated, as cutting rates could add inflationary pressures.
The Dual Mandate of the Federal Reserve
The Federal Reserve has a dual mandate to promote maximum employment and price stability. A slowing economy or rising inflation is a circumstance that policymakers want to avoid. But as an economist, I’m increasingly concerned about the risk that they happen at the same time – a horrible economic condition known as stagflation – and that the Fed may be too slow in responding. The evidence suggests that businesses are reluctant to add workers as tariff policy and broad economic uncertainty appear to drive hiring decisions.
The Last Time the US Experienced Stagflation
The last time the US experienced stagflation was in the 1970s, when an oil embargo caused the price of crude to double. This drove up inflation while causing unemployment to soar and the economy to stall. Policies aimed at reducing inflation typically exacerbate slowing growth, and vice versa. The pain experienced during this previous bout of stagflation convinced a generation of economists and policymakers that the condition was to be avoided at all costs.
The Impossible Decision
The Fed now has to make what seems like an impossible decision: cut rates even if doing so will add inflationary pressures. And there are other potential headwinds for the US economy, such as the impact of Trump’s immigration crackdown on productivity and output, waning consumer confidence, and a potential federal government shutdown. In my view, it’s clear that a cut is warranted, but will it drive up inflation? Economists like me will be watching this closely.
Conclusion
In conclusion, the Federal Reserve is facing a difficult decision, with both a slowing economy and rising inflation posing significant risks. While a rate cut may be necessary to boost economic activity, it could also lead to increased inflation. The Fed must carefully consider its options and make a decision that balances the need to promote maximum employment and price stability. As the economy continues to evolve, it’s essential to monitor the situation closely and be prepared for any potential outcomes.
