Trade Wars Likely to Change the Fed’s Interest-Rate Game Plan

The trade war has taken a harsher turn, threatening to further dampen economic growth. We expect the Fed to respond with sizable rate cuts, but the timing and amounts are more speculative than normal. Why? Economic data haven’t yet taken a major downward turn, and there’s uncertainty over how the Fed will react.

With news that the US is pursuing sanctions against China and Mexico, the two-front trade war has caused markets to dramatically rethink the economic outlook and monetary policy expectations—more than two rate cuts are now priced in before the end of 2019. In our view, the odds of a more negative economic outcome have indeed risen. The US’s trade relationship with Mexico may be smaller than the one with China, but it’s more important from a macro perspective because of the deeply interwoven supply chain between the two countries.

The use of trade policy as a tool to achieve other policy objectives (immigration policy, in this case) will likely dampen business sentiment and investment, particularly given that a trade deal with Mexico was already assumed to be in the rearview mirror. Even if the threatened tariffs don’t go into full effect, the damage may already be done. Also, Mexico was a potential alternative to businesses that needed to rejigger their supply chain to adjust to tariffs on China; that option is no longer as appealing.

A Negative for US Growth—More So Globally

The US economy is already slowing from last year’s fiscally boosted growth, and many other economies are already struggling, making the intensified trade war a challenging headwind. But it’s not easy to estimate the impact. Financial markets seem to be very pessimistic, with bond markets already pricing in a US recession in the next couple of quarters.

We think that’s an exaggeration. Yes, growth will suffer, but the US has advantages over other economies. The biggest: The Federal Reserve is in a position to respond to a negative growth shock. Policy rates are lower than they were in past cycles—but higher than in almost any other developed country. As we’ve noted, inflation is, if anything, too low. That gives the Fed the leeway to cut rates as needed to support the economy, which should be enough to stave off the most negative outcomes.