Gaming the Fallout from a Trade War on the Fed's Rate Plans

(Bloomberg Opinion) -- The U.S. economy is charging through the second quarter at a growth rate that currently looks to be faster than 3 percent, and I have argued that an interest-rate increase by the Federal Reserve this week and in September are basically a lock. What could go wrong with this forecast? Plenty. 

For example, there's the potential contagion from either an emerging-market or European financial crisis. Also, the economy faces an imminent threat from the Trump administration’s decision over the weekend to escalate an already ill-advised trade war. These events could roil the Fed’s plans, possibly leading to an early pause in the tightening cycle. 

But we can’t rule out the possibility that a trade war has the opposite effect on monetary policy with toxic outcomes for financial markets. Currently, the Fed looks on course for three --and maybe four -- rate hikes in 2018 of 25 basis points each. With economic growth sufficient to put downward pressure on an already low unemployment rate, central bankers will seek to push policy rates to a neutral level. Otherwise, the Fed believes the economy faces a risk of overheating.

Escalating trade battles potentially impact this forecast by causing demand to contract and supply shocks. An example of negative demand shocks are retaliatory tariffs on U.S. manufactured goods and farm products. If America’s trading partners focus primarily on tariffs that narrowly target firms in Republican leaning states, such as levies on Tennessee whiskey, Harley-Davidson motorcycles and cheese, the overall impact on economic activity will be fairly minimal. 

Narrowly targeted retaliation by our trading partners will thus induce more political and local pain than aggregate weakness. And note that some of the overall damage on manufacturing will be mitigated by the rebound in oil prices and associated increase in drilling activity. If the overall economic impact of such retaliation is minimal, so too will be the Fed’s response. To be sure, if the negative demand shock is stronger than I expect, the Fed will see diminishing risk of overheating and change policy in a more dovish direction.

More interesting than demand shocks, which have straight forward implications for policy, is the possibility that the Trump administration’s approach yields an escalating supply shock that restricts the productive capacity of the U.S.  Such shocks both constrain economic activity and raise prices. The U.S.-imposed tariffs on steel are a perfect example. Indeed, the possibility of a broad-based disruption from such tariffs is exactly why a nation should be wary of targeting intermediate goods in a trade war.

It is tempting to conclude that the Fed will react to a negative supply shock via tighter policy, especially when central bankers already face the prospect of an overheated economy. This, however, will not be the case as long as the Fed believes inflation expectations remain well-anchored. Rather than shift to a more hawkish stance, the Fed will look through any spike in prices as temporary and instead focus on the negative impacts on economic activity. If they conclude that those negative impacts will continue even after the price shock fades, central bankers might even shift to a more dovish stance.

The Fed would be driven in the opposite direction if the economy faced a series of negative supply shocks, global trade conflicts escalate and those shocks trigger a change in consumer behavior such that inflation expectations become tilted to the upside. That kind of shift occurred in the late 1960’s, leading to the Great Inflation period. With that episode still looming large in the Fed’s psyche, policy makers would respond with a more hawkish policy stance.

The last case represents a worst-case scenario for financial markets, in that it's a toxic combination of faster inflation, weaker growth and tighter monetary policy. It would also put the Fed in the Trump administration’s crosshairs. I very much doubt President Donald Trump would sit quietly and respect the Fed’s independence if economic growth faltered. To be clear, this is not my baseline scenario. My baseline is that the scope of the trade impacts in aggregate are too limited to change the direction of policy. But market participants should remain wary of risks to this baseline. 

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