Investing.com -- The tariff policies implemented by the Trump administration could potentially lead to a major shock in the U.S. economy, according to Federal Reserve Governor Christopher Waller. Speaking on Monday, Waller suggested that the Federal Reserve may need to cut interest rates in order to prevent a potential recession. This action may be necessary even if inflation remains high.

Waller noted that the Federal Reserve is currently caught between two potential outcomes. On one hand, the economy could slow significantly, leading to an increase in unemployment to 5%. On the other hand, the situation may not be much different from a few weeks ago if the tariffs turn out to be a negotiating tool.

Waller stated that if the full set of tariffs proposed by President Donald Trump remains in effect, the impact on inflation could be temporary. However, the effects on output and employment could be longer-lasting. "If the slowdown is significant and even threatens a recession, then I would expect to favor cutting the...policy rate sooner, and to a greater extent than I had previously thought," Waller said.

In a scenario where the economy slows rapidly, Waller suggested that the risk of recession could outweigh the risk of rising inflation. This is especially true if the tariffs’ inflationary effects are expected to be short-lived.

However, if negotiations limit the tariffs to an average of around 10%, the outlook for monetary policy may not change significantly from before March 1. This is the date before the Federal Reserve’s last meeting and the majority of the tariff announcements. In this case, Waller expects inflation to continue on its path towards the Federal Reserve’s 2% target. He also mentioned that rate cuts could be considered in the latter part of the year if the tariff effect on inflation is relatively small.

Despite entering the year on a solid footing, Waller noted that the economy could slow, but not as dramatically if tariffs remain at an average as high as 25%.

Waller emphasized that part of the challenge for the Federal Reserve is understanding the administration’s direction. "The new tariff policy is one of the biggest shocks to affect the U.S. economy in many decades," Waller said. "Given that there is still so much uncertainty...I have struggled, like many others I have talked with, to fit these varying possibilities into a single coherent view of the outlook."

In March, the Federal Reserve maintained its policy rate in the 4.25% to 4.5% range, projecting three quarter-point rate cuts this year. However, officials have acknowledged that the tariff policy, referred to by Waller as the "elephant in the room," has made even the short-term outlook unpredictable.

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