The Federal Reserve has been shifting its policy guidance in a more hawkish direction during the first half of this year, with its “dot plot” now suggesting wide support for four rate hikes of 0.25 per cent in the current calendar year, as opposed to two or three hikes at the end of 2017.
However, an entirely new economic shock is now gaining momentum. The US administration seems determined to ratchet up the scale of tariffs on Chinese imports (see Martin Wolf). What initially seemed to be a skirmish with minimal effects on the economy has now become a more significant policy change that is difficult for the FOMC to ignore.
Investors will soon be asking an important question: in a bad scenario, can we expect a “Powell put” to take effect for risk assets, with the Fed coming to the markets’ rescue by tilting its policy guidance in a less hawkish direction?
The Fed staff is still in the very early stages of analysing these new issues, many of which are political or game theoretic in nature, and therefore hard to model. A plausible escalation of the tariffs could add 0.5-1 per cent to US inflation at a time when it is already above target. But the trade war could also reduce real GDP growth, pulling the Fed’s policy stance in the opposite direction.
With unemployment now well below the natural rate, and the fiscal stimulus still building, some policymakers might become more hawkish in response to an inflationary tariff shock. But that conclusion is unlikely to dominate within the FOMC. At least initially, a dovish reaction seems more likely.
The Fed’s opening presumption could be that the tariff shock resembles an adverse supply (or cost push) shock to the economy, while also reducing aggregate demand. According to the standard central bank playbook, the impact on policy would depend mainly on what happens to inflation expectations. The Fed is likely to assume that expectations will remain “well anchored”, in which case their initial policy guidance may shift in a less hawkish direction than existed before (see box below).
This seems consistent with the tone that has been adopted by the FOMC minutes in June and other recent Fed comments. The minutes stated that businesses are delaying investment decisions because of uncertainties about tariffs, though chairman Jay Powell said very clearly in his June press conference that these reports are not yet being confirmed by any hard evidence that the economy is actually slowing yet.
The chairman will be pressed on this topic in his congressional evidence next week. He will probably argue that the effects of the trade wars are likely to be damaging to business spending, while also having adverse, but temporary, effects on inflation. The FOMC will be monitoring any changes in financial conditions indices as the dollar and asset prices react to the tariffs. So far, the effects on the Fed’s FCIs have been small.
If the Fed’s message is mildly tilted towards a dovish reaction to the tariffs, interest rates will still remain on a gradual upward path. But the markets will become significantly less worried about the trade wars, and the dollar might lose some of its upward momentum.
There are important cross currents at work here, so the Fed is likely to tread very carefully. Any “put” offered to the markets by Mr Powell in response to the trade wars will certainly be very tentative and subject to even more caveats than usual.
How should a central bank respond to the imposition of tariffs on imported goods? The FOMC will probably adopt a base case in which the tariffs are borne mainly by US consumers, not by foreign exporters to the US. They may also assume that the tariff revenue is used by the federal government to pay down debt, rather than to increase government spending or cut taxation.
In that base case, a standard New Keynesian model would treat the tariffs as a cost push shock to the economy, somewhat similar to an oil shock. Reported inflation would rise as the tariffs are passed into the core and headline consumer price indices, and gross domestic product growth would be reduced as real consumption declines and corporate investment is postponed because of increased economic uncertainty.
According to a Taylor Rule, the outcome will be importantly affected by the impact on expected inflation in response to the higher tariffs. If expected inflation remains well anchored, then the Fed would be able to “look through” the immediate rise in reported inflation, leaving interest rates unchanged by that factor.
Meanwhile, if the Federal government does not spend the proceeds of the tariff, aggregate demand would drop. A lower GDP growth rate would leave unemployment higher than before, tending to reduce interest rates as a result. Overall, forward guidance on interest rates would therefore tend to shift in a less hawkish direction than before.
While that might be the simplest conclusion from the standard model, several other factors could come into play.
If Chinese exporters choose to cut their selling prices, they would bear some of the costs of the tariff, so the damage to reported inflation and aggregate demand in the US would be reduced. If the Federal government decides to use the tariff revenue to boost government spending, that would also increase demand in the US. These effects could induce the FOMC to view the tariffs more like a demand shock that would eventually require higher, not lower interest rates.
Retaliation by other countries, and shifts in the exchange rate, could also change the picture.
Finally, as Paul Krugman argues, if the tariffs are levied on intermediate and investment goods, instead of consumer goods, the immediate effects on inflation might be smaller, but the growth effects might be worse, and potential output in the long run equilibrium would be lower.
With historical evidence on trade wars rather scarce, these are major headaches for the Fed to address. Here is the Bank of England’s latest attempt: