Yesterday, Federal Reserve Board Governor Christopher Waller delivered a speech on the economic
outlook at the Certified Financial Analysts Society of St.Louis. Waller has been a key Fed governor because he’s been a “leading indicator” for changes and signals in Fed’s policy. He was the first to talk about QT back in 2021 and the first to signal rate cuts back in 2023.
He’s been right more often than not and the markets have always listened to his comments and reacted accordingly. We saw a reaction to one of his comments yesterday as well. The key line was that in case of a recession, Waller would favour cutting the policy rate sooner and to a greater extent than previously thought.
In his speech, he summarised the current economic outlook and provided two possible scenarios under which he would react in different ways. Long story short, he said that the economy was doing great before April 2 despite some weakening in consumer and business surveys due to uncertainty around tariffs.
Growth was solid even if it slowed a bit, the economy was at full employment and disinflation was back on track after a couple of disappointing months. Then came April 2 and everything changed. As of December 2024, the effective average trade-weighted tariffs for all imports into the United States was under 3%. Earlier in the year, the targeted tariffs brought that level to 10%. But the April 2 tariffs increased the level to 25% or more. A level that the US has not experienced for at least a century.
Scenario #1 – “Large tariffs” (25% on average or more)
Under this scenario, Waller expects inflation to peak around 4-5% and growth to slow down meaningfully. If market-based inflation expectations remain anchored, the weaker demand will put downward pressure on inflation eventually. The unemployment rate could rise to 5% by next year. Given that he expects the effect on inflation to be temporary, he would favour cutting rates sooner and to a greater extent than previously thought. Those would be “bad news” cuts.
Scenario #2 – “Smaller tariffs” (10% on average)
Under this scenario, Waller expects the effects on the economy to be much smaller. Inflation would likely peak around 3% and inflation expectations would remain anchored. He also expects that households and businesses would continue to spend and hire during the trade negotiations that lead to substantially reduced tariffs and possibly remove barriers to US exporters over time. With the threat of a sharp slowdown or recession diminished, the pressure to reduce rates would also diminish. In such a scenario, the Fed will likely cut in the latter half of this year and those would be “good news” cuts.
To sum up
The scenario #1 is bad news and would see the Fed cutting rates to combat a possible recession, while scenario #2 would be good news and would see the Fed still cutting rates on inflation progress but less aggressively than scenario #1.
The problem with the first scenario is that it’s based on the thinking that inflation expectations would remain anchored. I think we are in a different context and the risks for stagflation would rise meaningfully. Hope he’s right and hope Trump would go for scenario #2.
Highest conviction trades
On scenario #1, I would expect the stock market to do great as collectively lower trade barriers would be positive for global growth and the ease in recessionary/high tariffs fears would boost the risk sentiment. Commodities should also do nicely
