The recent cooling of the U.S. economy: Tariffs or Fed tightening?

The recent cooling of the U.S. economy has sparked a debate, with some commentators pointing to trade tensions and tariffs as the primary culprits. While it is true that tariffs can disrupt supply chains and raise costs, their impact on an economy the size of the United States is often overstated. Instead of focusing on external factors, a more accurate assessment of the current economic slowdown requires a look at domestic monetary policy. The Federal Reserve, by raising its federal funds rate and keeping it elevated for an extended period, has directly engineered a slowdown in economic activity. This policy tightens financial conditions, making it more expensive for businesses to borrow and invest and for consumers to purchase big-ticket items like homes and cars.

History provides a powerful precedent for this economic dynamic. In the early 1980s, under the leadership of then-Fed Chair Paul Volcker, the central bank aggressively hiked interest rates to combat rampant inflation. The federal funds rate soared to a staggering 20%, a move that successfully crushed inflation but also intentionally triggered a severe recession (see figure below: Fed Funds Effective Rate - Gross Domestic Product). This historical episode serves as a clear example of the Fed's immense power to slow down the economy through monetary policy. The current situation mirrors this playbook, albeit on a less dramatic scale, as the Fed's actions have systematically removed liquidity from the financial system and reduced demand.

To see this cause-and-effect relationship in action, one only needs to look at the data. A review of historical economic trends reveals a strong correlation between the federal funds rate and overall economic growth, as measured by GDP. The periods following sustained rate hikes often coincide with periods of economic contraction or slower growth. The data clearly shows that the real force at play in the current economic environment is not trade policy, but the deliberate and often-overlooked decisions of the central bank. For a brief discussion on this, along with a few other related topics, please refer to the video linked below.