Powell Signals Return Toward Inflation-First Strategy

On May 15, 2025, Federal Reserve Chair Jerome Powell delivered a significant speech at a Fed research conference, underscoring the potential upheaval in the U.S. economy stemming from supply-side shocks and positioning the central bank’s primary focus back on combating inflation. This pivot comes in light of emerging economic challenges, such as tariffs and environmental disruptions, which have the potential to disrupt supply chains and artificially inflate prices.

Understanding Supply-Side Shocks

In his address, Powell indicated that the U.S. economy could be entering a phase characterized by frequent and potentially persistent supply shocks. He drew parallels between previous supply shocks, like President Donald Trump’s tariffs imposed on imports and the disruptions caused by the COVID-19 pandemic, as well as severe weather events such as torrential rains impacting manufacturing prospects in regions like western North Carolina. These supply shocks pose a conundrum for the Federal Reserve because they can simultaneously inflate prices while also stifling economic growth.

The Federal Reserve faces a challenging balancing act: if they raise interest rates to combat inflation, they risk dampening consumer demand and potentially leading the economy into recession. Powell referenced a 2023 paper from the Bank of International Settlements, which revealed that conflicts among Fed officials tend to escalate during times of economic upheaval caused by supply shocks.

Reviewing the Fed’s Strategy

The Federal Reserve is currently concluding a five-year review of its monetary policy framework. This update is particularly timely, as the existing policy strategy, adopted in 2020, did not take into account the ramifications of supply shocks. During that period, the Fed’s primary concern was addressing stagnation, with its benchmark interest rate often hovering around zero.

Powell highlighted that the pandemic has since altered the landscape of long-term interest rates, which have seen a significant rise compared to the 2010s. He posited that these increased rates signal the potential for greater volatility in inflation rates in the upcoming years. The critiques of the 2020 framework have been that it lacked clarity on how the Fed would navigate a surge in inflation.

Potential Amendments to the Framework

During his speech, Powell indicated that policymakers are contemplating crucial modifications to the Fed’s existing strategy. He mentioned two key aspects under review. The first involves reconsidering the Fed’s approach to employment metrics, moving away from solely focusing on “shortfalls” in job growth which might inhibit proactive inflation management. Powell affirmed that conversations among Fed participants indicated a consensus on revising the language surrounding these employment metrics.

The second anticipated change pertains to the Fed’s average inflation targeting, which allowed for some leeway above the 2% inflation threshold to compensate for historical undershoots. According to Sal Guatieri, a senior economist at BMO Capital Markets, this shift in strategy may not have contributed directly to the subsequent inflation spikes but certainly played a role in the overall economic context.

The Implications of a New Strategy

Powell emphasized the necessity of ensuring that the new framework is robust enough to withstand various economic fluctuations. Krishna Guha, vice chairman of Evercore ISI, noted that the revisions in these two focal strategies would signal a departure from the previously favored easier monetary policies and rate cuts.

While some criticisms of the 2020 framework may have been exaggerated, Guha articulated that at the very least, the strategy became less relevant under the current economic challenges and may have inadvertently contributed to the Fed’s overreach during the pandemic recovery period.

Acknowledging the Risk of Zero Interest Rates

In his remarks, Powell did not shy away from acknowledging the persistent risk of interest rates falling back to zero, reflecting on the history of cuts that have typically ranged around 500 basis points during economic downturns. As it stands, the Fed’s benchmark interest rate currently fluctuates between 4.25% to 4.5%, indicating a more complex economic landscape compared to previous years where rates were confined to near-zero levels.

Conclusion

As the Federal Reserve braces for potential supply shocks that threaten to destabilize the economy, Chair Powell’s calls for a renewed focus on inflation management underscore an evolving economic narrative. With a thoughtful reassessment of its existing strategies, the Fed aims to navigate the complexities of an economy poised between growth and inflation. Investors and economic stakeholders will be closely monitoring these developments, anticipating changes that could reshape financial landscapes in the years to come.