The Fed’s tariff blind spot and how to correct it

Financial markets have convulsed several times since President Trump’s “Liberation Day” imposed higher tariffs on many American trading partners. Capital flight, an uncommon occurrence in the usually financially sound United States, is a signal that investors are bracing for prolonged uncertainty. The International Monetary Fund quickly slashed its global growth forecast, blaming policy-induced turbulence rather than underlying economic weakness.

This isn’t a new phenomenon. Over the past few years, trade policy uncertainty has become an all-too-familiar driver of market volatility, proving repeatedly that tariffs do more harm through financial markets than through direct price effects. Yet, the Federal Reserve still relies on old-fashioned monetary tools: moving interest rates incrementally, quarter-by-quarter, based largely on a combination of backward-looking inflation data and noisy forecasts of future inflation.

A groundbreaking paper by Ricardo Caballero, Tomás Caravello, and Alp Simsek explains why this conventional approach falls short and proposes a compelling alternative: targeting financial conditions directly. The Fed, they argue, should announce a clear target for the Financial Conditions Index (FCI)—essentially, an index combining measure of stocks, bond yields, credit spreads, housing prices, and exchange rates that directly influence economic activity—and commit to adjusting its policy rate to keep actual conditions aligned with this target.

This strategy precisely tackles the volatility that tariff announcements generate. Such policy “noise” shocks—like sudden tariff tweets or trade-war escalations—can swing markets wildly despite having minimal direct economic impact. In fact, Caballero and co-authors estimate these shocks account for around half of all market volatility and nearly as much economic disruption. By stabilizing financial conditions directly, the Fed could substantially reduce these disruptions, which frequently threaten turmoil. The Fed’s current toolkit is not robust enough to cover these problems.

Indeed, FCI-targeting would have done the opposite of the Fed’s actions so far. Under standard theory, tariffs act like a one-time negative supply shock. That is, they increase the price level permanently and there is little to nothing that monetary policy can or should do to address that. By contrast, an FCI-targeting regime would likely act quickly to stabilize markets and ensure a smooth transition.

Importantly, an FCI-targeting framework could better serve middle-class and lower-income Americans than the current inflation-focused approach. Inflation targeting often disproportionately affects essentials like food, fuel, and rent, and can lead to blunt interest-rate adjustments that harm lower-income families through higher borrowing costs and reduced employment prospects. By contrast, stabilizing financial conditions directly addresses the economic anxiety and financial insecurity that disproportionately impact ordinary households. It cushions families against volatility-driven downturns in the housing and job markets, preserving employment stability and maintaining more affordable borrowing conditions for homes, cars, and education.

The potential benefits are striking. Simulations based on recent decades show that FCI targeting could have reduced volatility in financial conditions by 55 percent, slashed economic output volatility by 36 percent, and even trimmed interest-rate volatility by 6 percent. Importantly, it achieves these outcomes without losing control over inflation.

Implementing such a strategy is simpler than it sounds. Typically, the Fed targets a particular inflation rate. Instead, the Fed would use its existing data to set a target FCI and use its existing instruments to close the FCI gap—the difference between the current FCI and the target. Even a modest step, like augmenting the traditional Taylor rule—which guides rate-setting based on inflation and employment—with a significant weight on the FCI gap, would reap substantial stability benefits without demanding new institutional structures or intricate models.

Policymakers should recognize that tariffs and the volatility they spawn won’t disappear anytime soon. By explicitly targeting financial conditions, the Fed wouldn’t need to guess whether a market move is fundamentally justified or merely noise. Instead, it could rely on a clear and simple benchmark, letting markets stabilize themselves with confidence in a steadier backdrop.

Indeed, policymakers should be especially keen to embrace FCI-targeting. While a clear link exists between macroeconomic theory and the resulting effects on financial markets, the link between theory and typical targets like unemployment and inflation is far more tenuous. Indeed, the prevailing academic literature and policy practice do not actually seem to agree.

Congress, too, should take note. As lawmakers grow increasingly concerned that market instability undermines economic well-being, an FCI-targeting approach offers a market-friendly, low-cost stabilizer aligned perfectly with the Fed’s dual mandate.

Recent market turmoil underscores how urgently the Fed needs this new playbook. In an era where tariffs or geopolitical spats can vaporize billions of dollars in market value overnight, stabilizing financial conditions isn’t just a prudent move—it’s becoming a necessity.