How Will Fed Prevent ‘Economic Fallout’? (Uncut) 04-12-2025

Former Fed President: How Will Fed Prevent ‘Economic Fallout’? | Jeffrey Lacker

I think that uncertainty is likely to by itself induce a substantial pullback in discretionary outlays by businesses and consumers. Now that they’ve sort of revealed that they’re going to negotiate after having said, well, no, they’re not going to negotiate. These are permanent.

They’ve sort of undercut their own credibility and it’s diminished. I think the faith anyone’s going to have in anything they say going forward based on the trade war or even notwithstanding the trade war. If we remove that completely, we’ll be still be heading for a recession.

We’re speaking today on the 10th of April. President Donald Trump has scaled back his tariffs, lowering tariffs to 10% on most countries that have not reciprocated. One important exception stands China.

Tariffs in China have now risen to 125% as of the 10th of April with Beijing saying that it will fight to the end. How will this trade war play out? How will it impact inflation, economic growth, jobs, employment? We’ll find out with our next guest, Jeffrey Lacker, Senior Affiliated Scholar at the Mercatus Center and the former president of the Federal Reserve Bank of Richmond from 2004 to 2017. He is also a fellow of the Global Interdependent Center’s College of Central Bankers.

It’s an honor to host you, Jeff. Thank you for joining the program. Thank you for being here.

My pleasure, David. Actually, before we get into the trade war, let’s talk about today’s CPI print. Headline inflation came down from 2.8% in February to 2.4% in March, so no direct or at least no noticeable impact on consumer prices for the tariffs so far.

Is that statement correct? That’s the way it looks, but prospects for a trade war may have had a heavy influence on hotel prices and airlines, which accounted for some of the drag on the core index. I think we’re starting to enter into kind of a fog bank with regard to economic data that’s going to cloud the Fed’s view of what’s going on for a little while. Yeah, and core inflation, like you mentioned, also came down 3.1% to 2.8%. Is it fair to say that the Federal Reserve, for now, does not have to worry about the trade war? Far from it.

There’s a lot to worry about in the trade war and what happens going forward. I think the cone of plausible scenarios going forward on macroeconomic data in the U.S. is exceptionally wide, very unusually wide. There could be a slowdown in real growth very definitely, but there also could be an acceleration of inflation.

Some combination of those two seems very plausible, but the magnitudes seem very unclear because the magnitudes of the tariffs that are actually going to be in place three, six months from now is very uncertain. So, I think the Fed’s got a lot of uncertainty ahead of it, a lot of challenges ahead in figuring out what the path is going to be and how they should react. Well, Fed Chair Jerome Powell has reiterated over and over again that he is going to remain data dependent.

You’ve been with the Fed. You were president of the Richmond Fed, like I mentioned, for 13 years. Has the Federal Reserve, especially during your time and now into the current administration, has the Federal Reserve changed the way they interpret data or look at data, or have they changed which data are more important to them over time? I think there’s been a focus on employment that’s been enhanced in the last five, six years with the framework review, the revised monetary policy framework in 2020.

That may be ebbing. I think inflation was obviously front and center the last few years starting in 2021. I think they’re a bit chastened by their experience.

I think they regret having waited so long into March of 22 before they started raising rates, and I think that’s going to weigh on their current revision of their framework, and I think they’re going to be eager to reestablish or, I should say, affirm and buttress the market’s perception of their commitment to price stability. That makes this current episode uncomfortable for them because they come in with inflation at running 2.8%, two and three quarters, essentially, by their favorite measure, the PCE core index. The recent trend has been that that’s been stickier than they thought.

The momentum of disinflation, of gliding down to 2%, seem to stall out in the last few months of last year and the beginning of this year. They’re starting from an uncomfortable place, and they’re entering a period where the extraneous influences on inflation are going to push it up in the interim. They’re in an uncomfortable place on inflation.

All right. Speaking of unemployment, here is the unemployment rate. It’s been hovering around 4%, 4.2% now, but it’s been ticking up steadily ever since 2023.

When you were at the Fed, the unemployment rate hovered anywhere between 4.5% and discounting the great financial crisis, which was an anomaly. It came back down to around the low of 3.6% right before the pandemic. What is an equilibrium unemployment rate, if there is such a thing, that the Federal Reserve would look at, above which things would start to look bad? Yeah, that’s a good question.

It’s a subtle one, and there’s some nuance that I don’t think are widely appreciated. If you look at that stretch from 2010 to 2019, particularly the first five years, up through 2015, it displays a characteristic that’s actually common to every recovery. The unemployment rate seems to fall in recoveries at about the same rate every time.

We don’t live in a world where the unemployment rate rockets up and then rockets back down again to a steady state. It gradually descends during the recovery. The picture that emerges, if you think about it in those terms, is that there’s a flood of workers looking for work in the stock of unemployed.

It takes a long time, and it’s a costly and time-consuming process, to reabsorb them into the labor force. I think this is a characteristic particularly of post-1980s recessions. Before that, several recessions in the 70s and early 80s were caused by the Fed.

People could return to the jobs they had before the recession that the Fed caused. In contrast, the recessions we’ve seen since the 1980s have involved sectoral reallocation, where one sector declines, their workers are thrown on the labor force, thrown into the labor market, and where they end up is not going to be the sector they came from. In the Great Financial Crisis, for example, a huge swath of workers related to residential construction and building trades were thrown into unemployment.

We weren’t going to build as many houses in the recovery, for sure, so they didn’t have the housing market to go back to. The struggle for the economy was what sectors should expand and pick up those unutilized resources. That’s a costly and time-consuming process because skills might not match where the expansion needs to take place in the economy.

You’ve got to move capital. You’ve got to have new businesses form and attract lending or investment capital to expand. It’s a costly process.

From that point of view, there’s a short-run idea about equilibrium and a long-run idea. I think when people talk about equilibrium unemployment or the natural rate of unemployment or maximum unemployment, at maximum employment, they’re thinking about what it looks like at the very end of an expansion, the very end of a recovery. We see down there unemployment around 4% in 2019 and 2020 before the pandemic.

Unemployment around 4% now seems like a fairly healthy equilibrium, you might call it, rate of unemployment. That’s fair enough. If it goes to, let’s say, 5%, then the Fed needs to take some action? I think if it goes to 5% and other indicators line up with the notion that there’s some slack in the labor market.

For example, if job openings fell relative to the number of unemployed, there might be a sense that, yes, that’s a weakness in real growth they need to counteract. I’m trying to understand, Jeff, the relationship between the change in the unemployment rate, the delta of this chart versus the monetary policy from the Federal Reserve. So take a look at the effect of Fed funds right here.

All throughout 2009 to 2016, the Fed funds rate stayed at zero. When looking back, we could see that the economy was in recovery mode. My question is why did the Fed choose to keep rates at zero when the labor market was in a period of improvement at the time? That’s a good question.

The way the question is usually asked is why didn’t they try to do more because the unemployment rate hadn’t gotten down to 4% yet. I think the answer is you asked in terms of equilibrium or the natural rate of unemployment. That’s best thought of, I think, is the rate of unemployment or the rate of employment, if you’re looking at it in terms of the stock of employment, that the economy can sustain without inflation pressures developing.

I think, arguably, the unemployment rate was close to the natural rate during most of that recovery. In that sense, monetary policy was doing all it could. Inflation pressures were contained.

Inflation was below 2%, never really surged above it materially. From that point of view, monetary policy was about right during that period. Well, that’s another interesting point.

All throughout 2010 to 2016, as you recall, the inflation rate was stable, like you mentioned. Just looking at this in isolation, one could make the argument, well, if we bring the Fed funds rate back down to zero tomorrow, let’s say, well, not tomorrow, that would be too drastic, but in this next cycle, we wouldn’t see a dramatic rise in inflation because that’s not what happened the last time. Is there anything wrong with that statement? Yeah.

This is the thing. The inflation rate was low and stable. Now, it’s a little higher than 2%, closer to 3%.

The stance of monetary policy really has to do with real interest rates. The nominal interest rate, say the one-year or two-year treasury rate that it induces, that current policy and expectations of near-term policy induce, minus what’s expected to be the inflation rate. Back in 2012 there, 2010, the real interest rate was minus 2%, say.

It was zero minus inflation rate of 2%. Now, with inflation running about two and three quarters, the Fed funds rate induces, it’s a higher real interest rate, a little above zero, but that real interest rate, that’s not something the Fed can push around on a sustained basis. The Fed can move it in the near term, but in the longer run, it’s driven by productivity growth and the balance of savings and investment, certainly in the United States, but in some sense globally as well.

This is the question of R-star. It’s often said that R-star was low in the 2010s. Available indications suggest that it’s risen since the 2010s and should now be thought of as something closer to 2% rather than the half a percent that estimates suggested for the 2010s.

Okay. Do you think we’re heading for a recession this year? I think it’s more likely than not. Okay.

Based on the trade war or even notwithstanding the trade war, if we remove that completely, will we still be heading for a recession? Yeah. The tariffs, if implemented at either this level, 10%, or even with the reciprocal tariffs, but even at this level, are a tax that’s large enough to have the potential to push the economy into a recession, but more broadly, I think that the uncertainty around what tariff policy is going to, the configuration of tariff policy is going to be in six months or 12 months or even two years out, I think that uncertainty is likely to by itself induce a substantial pullback in discretionary outlays by businesses in terms of hiring commitments and investment and consumers, durable goods, travel, and the like. And then on top of that, you don’t have Canadians visiting as much in as many numbers as they used to.

Yeah. That is a shame. I will continue to go visit my American friends.

I don’t really care about the trade war, but let’s take a listen to what Scott Besant said recently, and we’ll react together. And we saw the successful negotiating strategy that President Trump implemented a week ago today. It has brought more than 75 countries forward to negotiate.

It took great courage, great courage for him to stay the course until this moment. And what we have ended up with here, as I told everyone a week ago, in this very spot, do not retaliate and you will be rewarded. So every country in the world who wants to come and negotiate, we are willing to hear you.

We’re going to go down to a 10% baseline tariff for them, and China will be raised to 125 due to their insistence on escalation. Okay. So my question is, first of all, what’s the reaction? But second, is this all theater? I mean, if all they want to do, the White House, if all they want to do is negotiate with their trading partners, why can’t they just pick up the phone and do so? Why implement tariffs first and then take them off? That’s a real good question.

So there’s the tariffs and what effect they might have. But then the way the administration is going about this, I think maybe shooting themselves in the foot isn’t the right word, but it is definitely making it difficult to achieve whatever objectives they have. So either the administration has had a secret plan to do this in order to induce negotiations, and if that’s true, then they’ve undercut their credibility because the message as of a week ago was sort of mixed.

There were some claiming it was to induce negotiations, and then there were some claiming this is a permanent change. It’s designed to reduce trade deficits. Now that they’ve sort of revealed that they’re going to negotiate after having said, well, no, they’re not going to negotiate.

These are permanent. They’ve sort of undercut their own credibility, and it’s diminished, I think, the faith anyone’s going to have in anything they say going forward. So that adds to, as I said, the overlay of just ponderous uncertainty in markets right now about what the regime is, what they’re aiming for, and how they’re going to behave in the future.

And I think that’s going to make it hard for them to settle markets down, hard for them to achieve what sort of reallocation of economic activity they’re trying to achieve. Even a baseline 10%, would that have any material impact on consumer prices this year? I think it would. I mean, the numbers, you know, sort of the back of the envelope numbers suggest that it’s pretty substantial on a pretty substantial portion of our import.

Which sectors do you think would be most negatively impacted when it comes to employment at least? Yeah, that’s pretty complicated. I haven’t dug in to trace those effects so specifically. But can you make a broad statement that the labor market would be impacted in some way? Yeah, I think so.

I think for sure. Okay. So what are Fred’s options then if what we discuss is going to happen, which is a modest rise in inflation, perhaps even a modest rise in unemployment? What is the FOMC’s course of action come May? I think they’ll be on the sidelines in May too.

I think they’re going to sit on their hands, wait to see what happens. How would you vote if you were still at the Fed? I would just stand pat. I think they got it.

They’re probably regretting now that they got a little ahead of themselves last year in September in cutting rates. I think they would have been better off if they cut rates a little more gradually at the end of last year. They would have brought down inflation a little bit more.

They’d be a little better position. But that’s hindsight. And those are bygones.

I think that going forward, they’re going to have to wait until they have substantially more clarity about what macroeconomic fallout is going to look like. Do you think that anything’s possible, but what would need to happen, theoretically speaking, to prompt the Federal Reserve to issue an emergency rate cut by May? I think you’d have to have employment falling out of bed. You’d have to have serious declines in employment.

And I don’t think you know, I don’t see that happening right away. It may happen, but it would be something like that. So it would have to be something like the climate of 2008 in January, where the business cycle peaked in late in December of 07.

And some data emerged and there was some financial market shenanigans in Europe over the Martin Luther King holiday, as we call it, in mid-January. And that induced an emergency cut and then a cut at the Federal Open Market Committee meeting later. But right now, employment seems to be chugging ahead.

So it’d have to be some massive layoffs. And I don’t see that happening right away. There’s a lot of tariff effects that tariff effects are going to roll out a little, you know, are going to be kind of gradual over several months, because a lot of goods have been brought in and are sort of sitting in warehouses and they haven’t paid the duties on them.

And they’re kind of, they have this incentive to build up the inventories to get them in there. But they don’t know whether they’re going to be duties on them now or whether the duties are going to come off. They’re going to sit them there.

There’s been a lot of stockpiling ahead of time, getting things in before the tariffs apply. So I think there’s some leeway. There’s some lead time there before they cut.

And I don’t think they’re going to cut rates dramatically. Now, there is a possibility if there were significant disruptions in the Treasury market. And I don’t mean just price changes, but I think if there were a significant increase in bid ask spreads and a withdrawal of liquidity by, you know, the dealer community in the Treasury market, I think the Fed could step in and buy Treasuries and turn around and do that.

That’s something that is possible. We saw some this week, we’ve seen some pretty significant yield swings in the longer sector, pretty severe steepening. So the moves have been dramatic, but they’ve been orderly.

As far as I know, they’ve been pretty straightforward and liquidity is held up. But if there was some dry up in liquidity, I think they react the way they did in March of 2020 and intervene in the Treasury markets. I’m not sure that’s wise for them to intervene.

But the fact that they did in March of 2020 is going to lead market participants to think that it doesn’t pay off to position some funds in a way to let them take advantage of widening bid ask spreads or falling prices. So we’re kind of going to get out of the way of the Fed so that could hasten, you know, the Fed’s intervention. Well, speaking of the Treasury market, here’s the 10-year yield.

So this huge spike up from 3.9% all the way up to 4.2% in one day, that was a couple of days ago when Trump raised his tariffs. Is it fair to say that higher tariffs on trading partners is bullish for the U.S. dollar and hence also bearish for bonds because yield spike? Are the tariffs bearish for bonds? Do new tariffs typically mean that yields will spike on the news? Yeah, it’s a good question. You know, there’s sort of some things that cross cut here.

To the extent that the tariffs reduce the growth outlook in the United States, you’d expect and you’ve seen people mark down their expected path of the funds rate, that would have the opposite effect on at least short term, medium term yields, two, three, four year yields. On the longer end, I mean, you’re looking at inflation prospects. And, you know, on top of this tariff stew, you have the prospect of a substantial fiscal impetus, you know, the big tax cuts coming.

That’s got a way on them as well. Okay. So is it fair to say that the market is pricing in higher inflation then with the yields coming up? Is that what’s happening? Yeah, it’s a good question.

I’m not quite sure. Okay. Yeah.

All right. Well, something to follow here. And then finally on trade relations long term.

So this came in from headlines here. Spain defends closer ties, trade ties with China after US warns against cutting own throat. Spain will pursue closer trade ties with China in the interest of its own citizens of the EU.

Its agriculture minister said on Wednesday, rejecting a US warning that moving closer to the Asian country will be cutting your own throat. Is that what’s going to be happening right now, that the allies of the US and trade partners are going to be moving closer to China and other areas and be less dependent on the US? Is this going to be a long term trend that we’ll see? Yeah, I think so. I mean, you’ve got one trading partner, the US, which since the 1930s has promoted lowering trade barriers, viewing it as both in their own interest and the interest more broadly of global peace and prosperity.

Instead, turning the other direction and shunning reduction in trade barriers. And it’s bound to lead other countries that still favor lower trade barriers to combine with each other in the trading block. So nothing about the US’s unwillingness to trade with low tariff barriers with other countries changes their incentives.

So yeah, they’re going to want to find partners to trade more freely with, I think. I’m just thinking based on what you just said, the US has been the global superpower ever since the 50s when it comes to many things, not just politically, militarily, also technologically, culturally, economically. Now that there’s more competition from China and perhaps some other places like the EU, I think that perhaps people are thinking, well, before free trade worked in America’s favor because market forces would naturally gravitate towards the world superpower, now that there’s more competition, wouldn’t it be fair to institute more protectionism? Does that logic make sense? Yes and no.

So protectionism comes in a lot of different flavors. And the concerns that many people have about China relate to national security and the potential for them holding us hostage with certain goods that we depend on in the event of hostilities with them. Yeah, that suggests some very targeted measures regarding China and very active investment in bringing activity back to the United States that you view as a national security concern.

It doesn’t suggest taxing islands with a bunch of penguins on them. So it’s this broad base spray of tariffs on everybody that doesn’t flow from the kind of strategic considerations that you cited. Okay.

Fair enough. Finally, what is your view on the U.S. dollar? I brought it up earlier. Do you think that the dollar is at risk of losing its reserve currency status? Will people lose confidence in the dollar because of the trade war? Let me just pull up a DXY chart so you can see what’s been happening here.

It’s lost a lot of ground since the beginning of 2025. Mm-hmm. Yeah.

So, yeah, the reserve currency status of the dollar is an important thing. And it’s driven by a bunch of things. The depth and liquidity of the foreign exchange markets of U.S. dollar bilaterally versus other currencies and the fact that a two-leg trade through the U.S. dollar is generally less expensive, or last time I looked, generally less expensive for a lot of currency pairs than going bilaterally.

And the widespread invoicing in U.S. dollars, I think, is going to continue to bolster the value of the dollar as a reserve currency. I think threats to it are kind of a little distant still. But yeah, if this persists, if this kind of whipsawing of markets persists, I think that could erode it more rapidly over time than it otherwise would erode.

Let’s end on a fun note here. Your experiences at the Fed, any funny stories you can share with us? Any closed-door meetings that stood out as memorable? I was a reserve bank president. We would go up the night before, stay at a hotel in Washington.

We’d all fly in. I would be driven up in an SUV, and then we’d go from the hotel to the Eccles building by a series of black SUVs. There was always a camera crew right outside the driveway that takes us down underneath the building.

I remember once there was a line of cars stopped there, and my car was right on the sidewalk, and there was a bunch of camera crews there. One of them looked in at me, looked at my face, and turned around and shouted to the other ones, it’s nobody. Not Greens fan, not the vice chair, you know, Tim Geithner or whatever.

You’re rapidly disabused of the notion that you have the star power that Greens fan has. But in reality, maybe for the folks who don’t know, how does the president, or any one sitting president, influence the decision of the FOMC overall? How does the voting process and decision-making process work? Yeah. So going into a meeting, the chair and his two closest advisors on the committee, which would be the vice chair of the Board of Governors and the president of the New York Fed, have lined up what they want to do.

They’ve drafted a statement that they want to be adopted. They’ve decided whether to cut rates or not by how much. They send that out the week in advance, and then the chairman calls everybody, has a one-on-one call with everybody, and takes their temperature.

And if he needs to adjust, of course, he will over the weekend. But generally he’s lined it up pretty well. So at a given meeting, things are baked, but the meetings are pretty long anyway, they go for two days.

So what happens is people are giving statements that have to do with positioning for the next meeting. So it’s an ongoing conversation where what you say this meeting about the stance of policy and the economy is really about what you think they should do at the next meeting. Has any one meeting changed the chair’s mind? Oh yeah.

So in August, 2011, the transcripts, you should read it. I mean, it’s a wild meeting. I mean, the statement is distributed in advance, but they distribute it with two alternatives.

There’s A, B, and C. And we’ve always voted on alternative B while I was there, except for one meeting, August, 2011, they changed to alternative. Because in the meeting, if there’s a lot of things going on, people will suggest edits to the statement. And we made so many edits.

And so many of the edits were, well, let’s take this sentence from A and put it in here in B. And then someone said, well, why don’t we just use statement A instead? And it was a little bit of embarrassment because the first paragraph of the statement is sort of a summary of economic data. And the three statements are dovish, what the chairman wants, and then more hawkish, right? A, B, and C. And so they write the first statement to be kind of in tone consistent with A or C, hawkish or dovish actions. And so the A statement was really gloomy.

The first paragraph was noticeably more gloomy than people were expecting. And so some commentators noticed that. It was a little bit of whiplash.

But anyway, there was back and forth. There were three dissents at that meeting. But at one point, there were two dissents announced.

And then there was a third person, Plosser, who was on the edge, on the fence about whether to dissent or not. And Bernanke offered him a change in the statement to get him to not dissent. And he said, well, let me think about that.

While he was thinking about it, someone else said, well, if you do that change, I’m going to dissent on the other side. And so Bernanke backed off and just took three dissents at that meeting. So yeah, there have been some crazy meetings.

One final question, and I’ll let you go, Jeff. Having worked at the Federal Reserve as president for more than a decade, what are one or two or just maybe one of the major lessons you’ve learned about how the economy works, about how our financial system works, about how the Fed influences the economy that maybe you didn’t know before you had joined the Fed? So I’ll take you to be asking about before I joined the FOMC, which was 2004. I joined the Fed in 89.

I hardly knew anything then. So humility is the major takeaway. That there are very often multiple theories that are consistent with different points of view about what policy should be and different ways of interpreting the data.

And the limits of our understanding were impressed upon me by the whole experience. So yeah, I took away that we should be very humble about what we understand about how things work. Excellent.

Well, thank you very much. We appreciate your candor and your insight, Jeff. Where can we learn more from you and follow your work currently? JeffreyLacker.org. I update it regularly.

I don’t do any blogs or anything, but I put my stuff up there. All right. We’ll put the link down below so make sure to follow Jeffrey Lacker there.

Thank you very much, Jeffrey. We’ll speak again soon. Take care for now.

Great. Thanks, David. Thank you for watching.

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