Federal Reserve Board Governor Christopher Waller discussed the economic outlook in a speech, outlining two scenarios with different responses. Before April 2, the economy appeared robust despite some survey weaknesses, maintaining full employment and progressing towards disinflation. However, increased tariffs on April 2 altered the landscape significantly.
Large Tariffs Scenario
The first scenario, “Large Tariffs” of 25% or more, predicts inflation peaking at 4-5% with slowed growth. Waller believes inflation would eventually decrease due to weakened demand, potentially raising unemployment to 5% next year. In this case, he supports cutting rates sooner and more aggressively. If inflation expectations do not remain steady, stagflation risks grow, adding complexities to the economic outlook.
In the second scenario, “Smaller Tariffs” of 10% on average, Waller expects less impact, with inflation around 3%. Consumer and business spending is likely to persist, lessening pressure on rate cuts. This scenario leads to potential rate cuts later in the year, reflecting economic recovery rather than recession response.
Market reactions vary between scenarios. Under large tariffs, gold may rise with stagflation fears, while a temporary stock rally could give way to a selloff. Under smaller tariffs, stocks might perform well, benefiting from eased trade tensions and lower recession concerns. Commodities could flourish, and bonds might stabilise, reflecting improved conditions.
Response to Trade Policy Shifts
Waller’s remarks point to a delicate balancing act in response to recent trade policy shifts. Before the tariff increases on April 2, most data suggested that inflation pressures were easing and that employment levels remained high. Despite soft readings in some business and consumer surveys, the general sense was that the economy was still moving in the right direction. That has now shifted quite abruptly.
His first scenario deals with large, abrupt import costs hitting the economy, and the effects here are not subtle. With tariffs of 25% or more, we’re looking at inflation moving sharply higher in the short term. In such a case, Waller expects that price increases will eventually cool not because of smoother supply chains but because demand will start to falter. Households may pull back when routine purchases become costlier, and businesses could respond with hiring freezes or even cuts. That could push unemployment up noticeably, which would give policymakers a reason to act sooner and faster with rate reductions.
In this harsher environment, traders should be very explicit with their expectations for inflation-linked assets. Any temporary equity rally driven by initial trade optimism—or by assumptions that policy easing might support valuations—may be fragile. On our side, we’d be looking more closely at inflation swaps and long-end break-evens. Not all inflation is created equal, and in this case, it’s emerging not from overheating demand but from supply disruptions. That matters for hedging.
On the commodity side, Waller’s formulation suggests renewed interest in metals or softs markets, given likely safe-haven flows and pricing power from producers. Bonds, meanwhile, face an awkward period where rising inflation meets weaker demand. That’s a condition which often leaves fixed income investors with few low-risk options unless rate expectations adjust quickly.
The second path Waller outlines is more benign. Tariffs of around 10% aren’t negligible, but they don’t cause the same degree of disruption to business input costs or household spending. Inflation would still hover above targets, but not to the point where it dents momentum. Here, the tone becomes more familiar—perhaps even predictable. Spending would stay broad-based, and pressure would grow conditionally over time for moderate rate reductions but only after progress is confirmed.
In markets, these two branches are not theoretical. We should think practically: implied volatility for both rates and equities will tell us which scenario is gaining traction among traders. If the more adverse situation starts to dominate, one might see action in front-end vol rising—indicative of discomfort around the Fed’s path. On the other hand, if the lower tariff scenario prevails, then we can anticipate a flatter vol curve and steadier bond pricing.
Under the milder case, riskier assets are likely to catch a bid from renewed carry trades, while rotation into cyclicals could make sense if global growth shows spillover strength from reduced trade friction. Credit spreads would then narrow as confidence returns to private sector lending, at least incrementally.
Waller has drawn these scenarios not just to warn or reassure, but to stress that the timing of any policy response will hinge on how expectations behave. If households and firms begin to treat higher prices as permanent, then longer-term yields could climb independently of central bank moves. Inflation expectations, particularly five-year forwards, must therefore be watched closely.
What we draw from this is not just positioning ideas, but also the need for vigilance in implied rate paths. With Waller opening the door to quicker action in the high-tariff world and further out moves in the low-tariff one, near-dated options on Fed Funds futures may underprice the divergence risk. There’s room to explore more asymmetrical trades here—higher gamma, shorter duration.
This isn’t a case of waiting for clarity. It’s one of watching behaviour—of prices, of survey responses, of inflation prints—and acting in alignment with which scenario steadily asserts itself. The fluctuations in the gold market, S&P options, or even cross-currency basis points between the dollar and regional partners, could give the earliest signals. Monitoring these allows one to calibrate expectations for trades linked to real yield shifts, and ultimately, central bank bias.
