The Fed’s trade policy dilemma

How should the US Federal Reserve respond to president Donald Trump’s trade policy threats and actions? Trump’s latest tariffs on Chinese exports, some now scheduled for September, others for December, are heavily focused on consumer goods. By adding as much as 10% to the cost of the merchandise in question, will they push US inflation up towards target and leave the Fed less anxious to cut rates? Or will uncertainty about the trade policy outlook discourage investment, cause a further economic slowdown and rile the stock market, and in doing so give the Federal Reserve additional grounds for loosening?

In thinking about the appropriate course of action, it’s important for the members of the Federal Open Market Committee to distinguish two quite separate issues. First, are Trump’s tariffs inflationary or deflationary? Second, were the Fed to neutralise their impact, would it in effect be permitting President Trump to ignore the damage caused by his trade restrictions and encourage him to double down on the policy?

Academic research, for what it’s worth, suggests that the immediate impact will be inflationary – that the first effect to materialise will be higher prices at the Apple Store. But the same research also suggests that, over time, the effects will become increasingly negative. Uncertainty will be heightened. Extended supply chains will be seen as increasingly problematic. With the possibility of retaliation, foreign market access will become questionable. Firms, in light of these uncertainties, will hold off investing, so growth is likely to slow. Financial markets, which look forward, are already pointing in this direction. And if demand and spending fall, as the markets seem to be predicting, so too will inflation.

It’s the Fed’s job to ‘look through’ short-term fluctuations in inflation. In this case, doing so means loosening in response to Trump’s disruptive trade policy actions. Last year the Fed made the error of tightening in response to what turned out to be a temporary uptick in inflation. It shouldn’t repeat the mistake. 

After all, inflation in the US is nothing if not well anchored. There’s zero risk that temporarily higher prices during the Christmas shopping season will unmoor expectations and feed through into a persistent acceleration in inflation.

What about the danger that, by neutralising the negative macroeconomic effects of the Trump administration’s trade policy actions, the Federal Reserve will only encourage the president to resort to more of the same? This danger is real, but it is inappropriate for the Fed to put aside its dual mandate in order to defend the multilateral trading system. Raising rates or hesitating to cut them to demonstrate to the president the destructive nature of his trade policies would be tantamount to attempting to discourage protectionism by inducing or aggravating a recession. This would erode popular support for the institution – and quite rightly. It would put the Federal Reserve’s independence at risk, since political support for that independence is predicated on the central bank faithfully pursuing its legislatively given mandate to deliver high employment along with low and stable inflation.

Federal Reserve officials should make indisputably clear their view that Trump’s trade policy actions will damage the economy, if not now, then in the future

We’ve heard calls before for central banks to put aside their fundamental responsibilities in order to force other policy-makers to rethink. In the global financial crisis, it was suggested that central banks should spurn large-scale liquidity injections to force governments to more aggressively restructure and recapitalise their banking systems. Today, some observers argue that the European Central Bank should foreswear another round of quantitative easing in order to force fiscal policy-makers to take more responsibility for jump-starting European growth. 

The one thing these recommendations have in common is that they are equally wrongheaded. Central banks can’t solve all problems. Monetary policy shouldn’t be used to pressure other elements of the policy community to correct their mistakes. Central banks should stick to their knitting.

But this doesn’t mean that central bankers can’t use their bully pulpits. Federal Reserve officials should make indisputably clear their view that Trump’s trade policy actions will damage the economy, if not now, then in the future. So far, they have uttered a few cautious words about “trade-related uncertainty”. It is past due time to sound louder warnings. Doing so is eminently consistent with their mandate, since the deterioration in macroeconomic prospects caused by Trump’s trade policies affects not just inflation, but also productivity growth and potential output, all of which are directly relevant to the conduct of monetary policy.

No doubt stronger statements to this effect will attract the president’s ire. But the independence of their institution allows Federal Reserve officials to speak frankly and directly when they see other branches of government pursuing policies that damage the economy and complicate the formulation of monetary policy. If central bank independence isn’t good for this, then what’s it good for?