As Donald Trump takes office for the second time on Monday, Jan. 20, his incoming administration's agenda is of keen interest to the Federal Reserve. After cutting rates for a third straight meeting on Dec. 18, policymakers signaled a pause was likely to start in 2025, with Fed chief Jerome Powell citing "policy uncertainty" under Trump.
Trump has proposed extending and expanding tax cuts, easing regulatory burdens, sharply increasing tariffs and deporting millions of illegal aliens. Some of those policies could be seen boosting economic growth, increasing inflation, or both. Adding to the uncertainty is how fully he carries out his various agenda items and the order in which he carries them out.
For instance, Trump has threatened massive tariff hikes on China, Mexico and Canada on his first day in office. But Trump's incoming economic team, including Treasury Secretary nominee Scott Bessent, reportedly is mulling a gradual ramping up of tariffs, in part to avoid an inflation spike.
Unlike in 2017, inflation is still well above 2% as Trump takes office. The budget deficit is extremely high as a share of GDP, with entitlement spending skyrocketing for the foreseeable future. The so-called bond vigilantes are, at the very least, getting restless.
Here are four possible economic scenarios under Trump and the likely Fed response.
Trump Economy Scenario: Strong Growth, High Inflation
Assume that the economy runs hotter than expected, while inflation remains high or accelerates. This could be due to Trump policies or economic trends that are largely beyond his control. Obviously, the Fed wouldn't want to cut rates in that scenario.
Arguably, this scenario is not far from the actual situation as Trump prepares to take office. The U.S. economy isn't rip-roaring, but there's solid growth that's been surprising to the upside. Meanwhile, inflation is no longer trending toward the 2% target, with various indicators suggesting renewed price pressures bubbling up.
But if growth and inflation pick up from current rates, the Fed may need to tilt toward rate hikes.
Strong Growth, Low Inflation
In this scenario, the U.S. economy shows healthy-to-strong growth while inflation cools toward or even below 2%. Perhaps Trump's tax-and-deregulation agenda fuels investment, turbocharging productivity gains from the AI boom led by Nvidia and others.
In this scenario, the Fed probably could cut rates, but it wouldn't be a pressing priority.
Weak Growth, High Inflation
A stagflation scenario, with economic growth flagging or stalling out while inflation stays hot or picks up, is a terrible situation for the Federal Reserve. Higher tariffs (and any trade retaliation) or tight labor markets stemming from a crackdown on illegal immigration potentially could contribute to this.
Additionally or alternatively, if budget deficits worsen, the 10-year Treasury yield could push beyond 5%, lifting mortgage rates and other lending costs. That would weigh on economic activity — and further worsen the fiscal situation.
The Fed would want to cut rates to boost the economy. But in this scenario, that could push inflation even higher. Indeed, rate cuts in this case could be counterproductive for growth, because Treasury yields could surge if the bond vigilantes believe the Fed is losing control.
Trump Team Mulls Gradual Tariff Hikes To Avoid Inflation Spike
Trump Economy Scenario: Weak Growth, Low Inflation
If the Trump economy sputters, stalls out or seems headed for a recession with inflation cooling, the case for Fed rate cuts would be straightforward.
It's not clear what would push the economy toward a recession, but Europe, China and Canada have been sluggish for some time.
Of course, the Federal Reserve doesn't have a crystal ball to know how the Trump economy will play out. The current situation of modest economic growth and sticky inflation suggests a wait-and-see attitude by the Fed, especially after 100 basis points of cuts in the past three meetings.
Most of all, the Fed does not want to get into a situation where it needs to raise rates, especially after cutting briskly. Powell has warned repeatedly about the dangers of a 1970s-type scenario, in which the central bank would cut rates too soon, before inflation was truly under control.
Not only would that roil the economy, but it would ruin the Fed's credibility, still paper-thin after failing to recognize the magnitude of the inflation storm in 2021.
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