1Q26_ Quarterly Outlook Report_Final_EN - Flipbook - Page 16
T H E P LUMB LI N E | A RETU RN TO F I RS T PRI N CI PL ES
Accommodative monetary policy in many parts of the world may lend support to growth
Central banks like the Bank of Canada (BoC) and the European Central Bank (ECB) have reached
the so-called terminal policy rate as markets are not pricing in additional cuts from either. Others,
like the Bank of England and the U.S. Federal Reserve (Fed) likely have a bit more easing left in the
tank, while the Bank of Japan is an outlier having raised its policy rate a couple of times in 2025,
with further tightening a possibility in 2026.
With respect to the Fed, the median estimate in the latest Summary of Economic Projections,
from December, is calling for just one 25bps cut in 2026 versus market expectations that are
calling for roughly twice that amount. However, the dispersion of individual estimates among the
Federal Open Market Committee is wide with some officials forecasting multiple cuts and others
projecting no further easing, highlighting uncertainty around the future monetary policy path
stateside.
Adding further fuel to this uncertainty is questions around how tariffs are going to impact not just
the supply side of the ledger through its impact on firms’ input costs and ultimately inflation, but
also the demand side of the economy. Intuitively, tariffs may be interpreted as affecting the
former – import costs rise and companies will seek to raise selling prices, increasing costs for the
end consumer. However, this outcome assumes a 100% tariff pass through rate and inelastic
consumer demand. In the real world, businesses may hold off on raising selling prices or pass
through only a portion of the tariff to the consumer in order to preserve market share, while
consumers may tighten their purse strings and reduce spending, acting as a negative demand
shock.
A study from the San Francisco Fed delves into this. The authors conclude that every 10percentage point (ppt) bump in tariffs leads to a 1ppt increase in the unemployment rate in year
1 before the jobless rate moves lower in subsequent years. Such an increase in tariffs would result
in an immediate 1ppt decline in inflation, reflecting the demand shock, with prices beginning to
pick up over the next few years before settling closer to baseline.
The authors caution that their findings may not apply perfectly to the current environment which
has seen an unprecedented increase in global trade protectionism, but the ideas likely illustrate
a key consideration for Fed officials as they look to tune policy settings to foster maximum
employment and price stability.
U.S. monetary policy officials may also take into consideration the Supreme Court’s ruling on the
legality of tariffs and the avenues the White House may traverse to ultimately circumvent a ruling
that does not align with their motives, as well as the Fed undergoing a leadership change once
incumbent Chair Jerome Powell’s term sunsets in May. It is widely expected that President Donald
Trump will appoint a successor with dovish policy leanings to support his preference for lower
interest rates.
Although the market would likely welcome lower policy rates under a new dovish Chair, perceived
politicization of the Fed that damages its institutional credibility could have an adverse effect on
risk appetite. Investors require confidence that monetary policy will be guided by long-term
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