Should Federal Reserve use scenario analysis to handle trade war uncertainty?

“The other factor is just really uncertainty. What would you write down (in the dot plot)?” Federal Reserve Chair Jerome Powell said Wednesday, explaining why the FOMC’s median projection continues to show two cuts this year after the projections also showed lower GDP growth and higher inflation rate.

Powell’s main point is that the Fed still has the privilege to stay in “wait and see” mode to keep its interest rate at its predetermined path and wait for more details on President Donald Trump’s tariff, fiscal and immigration policies.

But is it possible for the Fed to be a bit more proactive than merely saying “we will be able to update you further when we know more details”?

One potential solution is for the Fed to adopt scenario analysis to communicate its monetary policy strategy regarding the trade war.

What is scenario analysis in the central banking world?

In 2024, central bankers around the world adopted this new tool to help facilitate monetary policymaking.

• Scenario analysis gained popularity among the central bankers after former Fed chairman Ben Bernanke in early 2024 recommended it to the Bank of England as one of its regular monetary policy communication tools.
• By laying out scenarios the economy could potentially encounter, central bankers can guide the public on how they think monetary policy would pivot if the economy doesn’t evolve according to their baseline expectations.

Scenario analysis itself isn’t a groundbreaking concept in central banking.

• In essence, the Fed’s annual banking system stress test is a form of scenario analysis. By setting out extreme economic conditions, the banks can then use models to estimate whether they can still fulfil their capital requirements under those economic situations.
• Also, central banks have long been using scenario analysis for internal policy discussions. One famous example was Fed staff had in 2018 conducted scenario analysis on how the tariff policy and different monetary policy reactions can impact the US economy.
• During the post FOMC meeting press conference on Wednesday, Powell also mentioned that the central bank’s staff had prepared placeholder trade policy scenarios, which generally assume “full tariff retaliation”, for internal discussion in the meeting and to give FOMC members a broad sense of the economic impact.

On the other hand, using scenarios as a tool to publicly communicate future monetary policy changes is a relatively novel concept. Many central bankers, not only in the UK or the US, have only started to incorporate this framework in their speeches and to explain the “what ifs” in their policy considerations.

‘Team scenario analysis’ in the Fed

Quite a number of Fed officials are already on board the “scenario analysis train”. For example, Fed governor Lisa Cook and Chris Waller as well as San Francisco Fed President Mary Daly, to name a few, had previously deployed scenarios analysis to discuss their thinking on how monetary policy could evolve.

Waller’s speech in October, given about three weeks after the central bank’s first rate cut in this cycle, is a perfect example of how Fed officials have been using scenario analysis in the past year.  In the speech, he laid out the case for further gradual reduction in interest rate along with two more alternative scenarios:

1. weaker economy may require faster rate cuts; or
2. unexpected inflation may necessitate a pause in rate cuts.

This is the typical usage, utilizing the scenarios to provide extra guidance on how the Fed was going to handle the trade-off between employment/economic growth versus inflation. If inflation growth remains elevated as a result of certain factors that are not within their baseline projection, they would keep interest rate at a higher level; otherwise, they can cut faster.

In a way, scenario analysis acts as a more flexible and more detailed version of forward guidance. As Bernanke explained in his recommendations to Bank of England:

“If (along with the central forecast) the central bank publishes alternative scenarios that indicate how policy would likely be set if the economy were to evolve in a manner different than expected, the public will be able to draw sharper inferences about the reaction function and thus better anticipate future policy actions.”

Given President Trump’s sometimes “chaotic” tariff policy, it seems beneficial for the public to have a clearer idea of how monetary policy would change under different trade policy decisions. People would then only have to worry about trade policy shifting but no longer have to guess how the Fed would react. Right?

Not a tool for trade war?

Intriguingly enough, central bankers at the Fed are so far a bit wary of using this communication device to handle the brewing trade war.

A notable exception would be St Louis Fed President Alberto Musalem’s speech on Feb 20. In that speech, he made a brief comment on how “higher tariffs and immigration policies” can constitute a scenario in which US disinflation would halt and longer-term inflation expectations become unanchored. In such a scenario, he would support the US central bank in adopting a more restrictive monetary stance.

Apart from him, Fed officials, including chair Powell, have so far shied from communicating their monetary policy preferences tied to trade war-related scenarios.

Comparatively, its counterparts north of the border are more willing to talk about the trade war scenarios.  The Bank of Canada, in its January Monetary Policy Report, published a quantitative analysis of how scenarios of the US imposing 25% tariff on all of its imports would impact Canada’s GDP growth and inflation. The result shows that Canada’s GDP growth rate would be 2.5 percentage points lower than otherwise in the first year.

Nonetheless, it also fell short of providing clear guidance by tying potential monetary policy changes with the scenarios.

‘Excellent tool’ for tackling tariff uncertainty

Is it a tool ill-suited for handling the trade war?

Michael Bordo, professor of economics at Rutgers University and a distinguished researcher on monetary policy and monetary history, disagrees. He told EconReporter that scenario analysis is “an excellent tool” for the Fed to handle tariff-related policy problems.

Bordo has long been a supporter of the Fed using scenario analysis to enhance its communication. In May 2020, he coauthored an NBER working paper to explain the benefit of deploying scenario analysis to tackle communication issues during the early Covid pandemic era.

Back at the early pandemic period, the US economy was surrounded by heightened uncertainty stemming from “medical and public health concerns”, factors that are not usually incorporated in conventional macroeconomic models. “In the face of such extreme uncertainty, the consideration of alternative scenarios could be helpful in weighing the relative benefits of alternative strategies, including potential unintended consequences and longer-run risks,” according to their 2020 paper.

Bordo thinks that scenarios could be used not only in the Fed’s internal communications and public speeches, it can also be incorporated in its Summary of Economic Projections, the quarterly publication which houses dot plots and other anonymized economic projections from all FOMC members.

An important consideration is, though, how to decide what scenarios to be chosen. “The use of scenario analysis requires careful narrative on why the scenarios are chosen,” Bordo said.

Just not ‘practical’, ex-Fed official says

A former Federal Reserve official, who wishes to remain anonymous, echoed that view, saying the difficulty of using scenario analysis right now is the problem of how to set correct scenarios.

“There is no problem in principle with tariff scenarios. In practice, given the uncertainty, it is not easy defining the scenarios that are most likely,” he explained.

Without a sufficiently clear picture of what the tariff policies will be, it would be difficult to develop suitable scenarios. Basing the analysis on unreliable scenarios may then bring more downside than upside in terms of effective monetary policy communications.

Scenario analysis may only be more useful “if policy options become clearer,” he added.

Bordo, however, doesn’t think this issue is detrimental to scenario analysis implementation. His solution?

“[E]mbed the narrative in history.”

Back in 2020, Bordo and coauthors suggested using previous pandemic episodes, like the Spanish Flu in the 1930s, as well as financial crises as input to develop relevant alternative scenarios and apply these scenarios to shed light on how monetary policy should react.

“With respect to tariffs, stories about the Smoot Hawley tariff in 1930 [can act] as a worst case scenario, along with other less dramatic events in US history,” he said.