Inflation Risks Ahead

Tariffs, Deficits, and the Inflation Risk Ahead

The U.S. economy may be heading for another inflation storm—and this time, the risks stem from growing government deficits, escalating tariffs, and a Federal Reserve unsure of its next move. On Wednesday, the Fed left interest rates unchanged, citing rising stagflation risks. But behind the scenes, officials are rethinking strategy and debating how to respond to mounting economic threats.

Inflation has not returned to the Fed’s 2% target since February 2021. After peaking at 9% in June 2022, inflation has fallen but remains stubborn. The causes of this inflation surge were not mysterious. In response to the COVID-19 pandemic, the federal government unleashed $5 trillion in spending, while the Fed created $3 trillion in new money to buy bonds and support markets. The result was predictable: an inflationary wave reminiscent of wartime finance—massive spending, borrowing, money printing, and wealth erosion via inflation.

This was not just poor foresight; it was a deliberate choice in response to crisis. But as the crisis passed, the spending binge continued into 2021. The Fed, slow to react, kept interest rates at zero for too long. By the time action was taken, inflation had already taken hold.

Now, with the threat of new tariffs looming and federal debt ballooning, we face the possibility of renewed inflationary pressure. Tariffs, like those proposed on Chinese goods, raise import prices and disrupt supply chains, creating stagflation—higher prices and lower productivity. Meanwhile, federal deficits continue to rise, fueling fears of more borrowing, bond issuance, and pressure on the Fed to monetize debt.

In this environment, the Fed faces hard choices. Lower rates won't fix supply-side shocks. But higher rates could trigger financial instability, banking stress, and further fiscal strain. Without meaningful reforms, inflation will remain a recurring risk.

What should be done?

First, the Fed must overhaul its inflation strategy. During its last policy review, it adopted “flexible average inflation targeting,” which justified short-term overshoots. That may have made sense at zero interest rates, but today, people are tired of high prices. The Fed should promise symmetry: if it once tolerated overshoots, it must now commit to undershoots—periods of low inflation to bring the price level back down.

Second, the Fed must protect its independence. It should resist political pressure to buy government debt, hold down rates, or finance stimulus through backdoor monetary support. That means rejecting future attempts to treat the Fed as a funding arm of the Treasury.

Third, act fast. The Fed must not wait for inflation to prove itself “persistent.” The last time it did, inflation took off. It should promise a quick, data-driven response to inflation surprises, even if politically unpopular.

Fourth, tolerate some price volatility. Not all price declines are bad. Trying to prevent any sector from experiencing deflation encourages broad inflation. Letting some prices fall is part of healthy adjustment in a dynamic economy.

Fifth, remove systemic financial risk. Interest rate hikes threaten highly leveraged banks and institutions. Future Fed action should be decoupled from the need to bail out vulnerable financial players. That requires encouraging more robust financial architecture now.

But the Fed cannot go it alone. Congress must help reduce inflation risk.

That starts with fiscal discipline. Lawmakers should avoid broad stimulus spending in response to every crisis. Spending should be targeted and temporary.

Next, rebuild fiscal space. Future borrowing must be credible—investors must believe it will be repaid. That requires growth-friendly tax reform and long-term spending control. Certain tax provisions in the One Big Beautiful Bill Act (OBBBA), for example, are designed to stimulate private investment in manufacturing, artificial intelligence, and advanced infrastructure. These reforms include accelerated depreciation for new capital investments, expanded tax credits for R&D and industrial innovation, and lower marginal tax rates for reinvested earnings.

By encouraging companies to expand and modernize their operations, such provisions have the potential to increase productivity, generate higher incomes for workers, and drive long-term growth. Importantly, the resulting economic expansion can also increase federal revenues without requiring higher tax rates, helping to restore fiscal stability while raising living standards.

Finally, Treasury should borrow long-term. When the Fed raises rates, short-term debt becomes costlier. Locking in low long-term rates now can reduce pressure later and support tighter Fed policy when needed.

In short, another inflation wave is coming—unless we act. A coherent strategy involving the Fed, Congress, and Treasury is the only way to prevent a repeat of 2022. Planning today is the price of stability tomorrow.