The Federal Reserve Bank of San Francisco has released a new Policy Calibration Tool that reveals how the right interest rate response to recent tariff increases varies dramatically based on whether policymakers believe tariffs primarily affect demand or supply in the economy. If tariffs predominantly affect demand, more policy accommodation may be warranted; if they predominantly affect supply, less accommodation may be appropriate. The tool is designed to help construct a monetary policy path that aligns with one's views of the economy and policy objectives, though the high uncertainty surrounding tariff effects implies a wide range of possible scenarios for the best course of action.
The Policy Calibration Tool computes the federal funds rate path that will best achieve the Fed's dual mandate of price stability and maximum employment given two inputs: one's economic outlook under status quo policy and one's preferred weight between the two objectives. The tool relies on policy multipliers estimated from historical data for 1990–2007, which show that monetary policy may take about a year to substantially affect inflation. The estimates also reveal that a federal funds rate shock large enough to bring inflation down about 0.1 percentage point after two years would be expected to increase unemployment about 0.3 percentage point over the same period, quantifying the unemployment-inflation tradeoff that monetary policymakers must grapple with.
To illustrate how the tool works, researchers applied it to two hypothetical tariff scenarios. In a cost-push scenario where tariffs increase production costs, inflation rises substantially to close to 6% before slowly reverting to the Fed's 2% goal over the long run, while unemployment also rises to 6%. In a weak demand scenario where tariff-related uncertainty depresses economic activity, unemployment rises to the same 6% level but inflation dips below 1.5% by the end of 2026, falling below the baseline forecast. The report cautions that these scenarios are illustrative and don't reflect any specific quantitative assessment of the actual effects of the 2025 tariffs.
The tool's prescriptions diverge sharply depending on which scenario a policymaker believes. Under the cost-push scenario, the PCT calls for raising the interest rate to fight off inflation, even though this comes at the cost of higher unemployment—the prescribed federal funds rate path rises sharply in the first year before gradually returning to near the baseline path. Under the weak demand scenario, the PCT calls for the policy path to go in the opposite direction: if uncertainty stemming from tariff or other policy changes leads to lower inflation, the tool recommends cutting the interest rate to help inflation revert faster to the 2% goal and unemployment revert faster to its natural rate. The report emphasizes that the PCT should be seen only as an indicative tool with important limitations, including uncertainty in the multiplier estimates and an assumption that the economy behaves linearly.
The uncertainty surrounding the effects of large tariff changes implies that uncertainty about the best course of action and thus disagreement among policymakers could be substantial. The San Francisco Fed's tool demonstrates that there's no one-size-fits-all policy path for responding to economic shocks—whether a policymaker wants to change their preferred interest rate path in response to tariff changes depends crucially on how they see these changes affecting their outlook for inflation and unemployment. The ability to compare multiple policy path scenarios can provide new insights for calibrating policy during times of economic uncertainty.