Where do we stand as 2025 winds to a close? Is our Federal Reserve Board (FRB) more concerned about inflation or unemployment? The FRB, in its role as the central bank, has a dual mandate of maximum employment and stable prices. When the economy is strong, unemployment is low, but inflation can increase. If the economy is weak, inflation is likely held at bay as consumers are wary of spending, but unemployment can rise as companies fear adding to their payrolls in an unprofitable environment. The FRB seeks a goldilocks economy. Not too hot, not too cold, but just right! The tool the FRB uses to adjust the economic climate is interest rates.
Think of the FRB as a driver and the economy as a car. When the car is moving too slowly, the FRB puts their foot on the gas by lowering interest rates. If the car is traveling too quickly, they put their foot on the brakes to slow the economy down. When the car is traveling at an appropriate speed, the interest rate policy is “neutral”. In other words, the car is coasting.
According to the Zaman model from the Cleveland Fed, as of Q2 2025, the nominal neutral federal funds rate is estimated to be 3.7%1. Since the current federal funds rate measures 4.0-4.25%, monetary policy is considered modestly restrictive.1 The FRB has their foot lightly on the brakes.
Chairman Powell claims the FRB will remain “data dependent”. Well, the data appears to be leaning toward a weakening of both inflation and the labor market. As a result, the FRB is likely to take their foot off the breaks this year by lowering to the neutral rate, and perhaps move to the accelerator next year adapting a stimulative posture.
Determining the impact of our recent tariffs on retail prices and the effect of artificial intelligence on the economy remains the most significant challenge facing chair Powell and company.
Tariffs should either lead to inflation, if consumers pay the tax in the form of higher prices, or higher unemployment, if consumers buy fewer goods. The FRB seeks to determine who is paying the tariff and how that will affect the economy. Currently, it appears that importers aren’t consistently paying the tariffs since there is no sustained year over year margin squeeze.2,3 Consumers don’t appear to be paying the cost of the tariffs either, given the relatively tame CPI numbers.4 This can change of course, and the FRB is undoubtedly watching the effect of these tariffs on prices and unemployment very carefully.
The FRB must also consider artificial intelligence. If AI raises labor productivity meaningfully, a likelihood in our opinion, the economy can produce more output with the same input creating a deflationary environment. This will allow the economy to run hotter (or the car to travel faster) without leading to inflation.
These productivity gains will likely take time, but the effect of tariffs on the economy will likely be felt more rapidly. The FRB balancing act continues later this month as they are scheduled to meet October 28th and 29th.
- https://www.clevelandfed.org/publications/economic-commentary/2025/ec-202508-neutral-interest-rates-and-monetary-policy-stance?
- https://budgetmodel.wharton.upenn.edu/issues/2025/7/15/import-surges-and-tariff-avoidance-the-short-term-impact-of-the-trump-administrations-trade-policies?
- https://www.citigroup.com/global/insights/tariffs-remain-front-and-center?
- https://www.frbsf.org/research-and-insights/publications/economic-letter/2025/05/effects-of-tariffs-on-inflation-and-production-costs/