Waller's Warning: Stacked Shocks May Unanchor Inflation Expectations

The compounding problem

Fed Governor Christopher Waller is framing the policy challenge bluntly. The question is no longer whether tariffs will show up in prices. The question is whether one supply shock layered on another changes the way households think about inflation.

Waller's recent remarks capture the concern: when people see a sequence of positive price shocks, they may revise their expectations upward even if each shock is theoretically transitory. In practice, that distinction collapses. A consumer who paid more for goods last year because of tariffs and is now paying more for gasoline because of the Strait of Hormuz closure doesn't parse supply shocks by origin. They just see prices rising.

This matters because long-run inflation expectations are starting to drift. The University of Michigan's May reading came in at 3.9%, up from 3.5% in April and well above the 2.8% to 3.2% range seen throughout 2024. Near-term expectations ticked to 4.8%. These are the kinds of numbers that precede changes in wage bargaining behavior, and that's when transitory shocks become self-fulfilling.

Tariffs never left the picture

The administration's tariff policy adds another layer of complexity. The Supreme Court struck down global levies last year, but new duties are already being lined up to replace them. Core goods and import prices are showing early increases in early 2026, which means the pass-through from tariffs is arriving just as oil is compounding the problem.

San Francisco Fed President Mary Daly suggested in recent weeks that looking through tariffs seemed reasonable when they were the only shock in play. That posture is harder to defend when you're also looking through a war.

The Fed's Beige Book captured the breadth of the pressure: energy and fuel costs rose sharply across all districts, attributed directly to the Middle East conflict. Input cost pressures extended beyond energy into metals like steel, copper, and aluminum, driven by tariffs. The channel through which inflation spreads is widening, not narrowing.

The policy bind

Waller has historically leaned toward rate cuts. That preference is now on hold. His latest remarks suggest the Fed could remain at current levels for an extended period if inflation risks outweigh labor market deterioration.

The labor market adds its own complication. Hiring has stalled, but the unemployment rate hasn't spiked. Waller noted that the break-even rate of hiring that sustains the current unemployment rate may be close to zero. That's not a picture of labor market strength. It's a picture of fragility masked by low churn.

If inflation expectations become unanchored, Waller said he would support raising rates. He isn't there yet. "At this point that action is premature. It is time to simply sit and watch how the conflict and the data evolve."

That's the bind. The Fed is caught between a stagflation tail, where inflation persists while growth softens, and a scenario where oil prices stabilize and the economy muddles through. Neither path is clear, and moving in either direction carries meaningful policy risk.

What to watch

The next month will be defined by oil and expectations. If the Strait of Hormuz remains closed and Brent stays elevated, headline inflation will continue to pressure the year-ahead numbers. The June Michigan reading will matter more than it typically does. A further drift in long-run expectations would change the conversation from watching to acting.

Credit spreads are worth monitoring here. They've been relatively sanguine so far, which suggests fixed income markets are treating the war as a growth headwind more than a systemic risk. If that changes, if spreads start widening materially, it would signal that the growth side of the dual mandate is deteriorating faster than the inflation side.

The Fed held through a similar uncertainty last summer when tariffs were the dominant narrative. They cut three times in the fall once the picture cleared. The question now is whether this year's shock resolves in a similar timeframe, or whether the stacking of tariffs and oil creates a more durable regime shift. Waller is clearly thinking about the latter.