When the top policymakers at the Federal Reserve met three weeks ago to set the course for monetary policy in the United States, they spent substantial time discussing the risks that a trade war posed to the economy, according to minutes of the meeting released Thursday.
Most Fed officials at the table “noted that uncertainty and risks had intensified,” and that tariffs and other trade measures “could have negative effects on business sentiment and investment spending.” They reported that some of their business contacts “indicated that plans for capital spending had been scaled back or postponed as a result of uncertainty over trade policy.”
What they didn’t discuss, at least as far as one can tell from the newly published minutes, was any strategy for the Fed to come to the rescue if trade wars began to act as a meaningful drag on the overall economy. Indeed, at that meeting, Fed officials “generally judged that, with the economy already very strong” and inflation running at about 2 percent, “it would likely be appropriate to continue gradually raising” interest rates.
There was no hint in the minutes that the Fed intended to use its power over interest rates in reaction to rising economic risks from trade wars.
That reflects a particular economic challenge as the United States imposes tariffs on major trading partners and those partners retaliate with tariffs of their own — a cycle set to escalate with $34 billion of Chinese imports to go into effect at midnight.
It’s not just that a multi-front trade war could slow economic growth. It’s that it would do so in a way the Fed would not be able to easily offset. The usual economic shock absorber is particularly ill-suited to a trade-induced slump.
That’s because a trade war simultaneously risks pulling growth rates down while pushing prices up. Anything the Fed seeks to do to cushion the blow on one side of that equation would tend to make things worse on the other side. So if, for example, the Fed held off on further interest rate increases to cushion a slump in investment spending, it would be doing so just as inflation was accelerating above the 2 percent the Fed aims for.
Prices for washing machines, for example, have risen in recent months amid new tariffs on washing machine imports. Tariffs on steel and aluminum have already driven up domestic prices of the materials, which could flow through in the form of higher inflation even for American-made goods that use the metals.
“I think of this as a standard supply shock,” said Tim Duy, an economist at the University of Oregon. “Tariffs are going to constrict the productive capacity of the United States, which means lower growth and higher prices. The Fed operates on the demand side. They don’t have the right tools for dealing with it.”
For the Fed, the nearest parallel may be an oil price shock caused by some geopolitical event, such as those that took place in the 1970s, or a food price spike caused by a drought. What those events have in common is that they are caused not by economic fundamentals — such as when oil prices rise because the global economy is booming — but by some external shock. They are bad for growth, yet inflationary.
In those cases, monetary policy orthodoxy tends to emphasize looking past a one-time bump in inflation caused by the shock, while paying more attention to whether higher prices — whether for oil or corn or aluminum — are leading people to expect continually rising prices. A couple of years ago, with the Fed struggling to achieve the 2 percent inflation level it targets and with prices consistently rising more slowly, that might have been welcome.
Now, though, the Fed is pretty much achieving its inflation goal already, and with the unemployment rate at a very low level by historical standards, there’s reason to think higher prices may be on the way soon even before the impact of tariffs. In projections released at the mid-June policy meeting, the median Fed official expected that inflation would be 2.1 percent this year and next.
That calculus could change if a trade war starts doing major damage to the financial system, such as by causing steep losses in stock and bond markets or by causing financial stress to banks. But while the stock market is down a bit in recent weeks as the war of words over trade has escalated, so far the pain from trade wars has been limited to specific companies and their workers and customers. It has not been a systemic crisis.
For the last 11 years, from the housing downturn in 2007 that turned into the global financial crisis in 2008 and a prolonged, sluggish expansion after that, the Fed’s tools were reasonably well suited to the challenges that presented themselves. The central bank became even more central than usual to every economic discussion.
But this time, the economic risks are different, and if conflict over trade practices starts to cause damage to the broader economy, we shouldn’t count on the Fed to bail us out.