The Developing Trade War and the Impact on Interest Rates

By ELLIOT EISENBERG

GraphsandLaughs, LLC, Elliot@graphsandlaughs.net

The U.S. economy is growing rapidly, and 2018 is shaping up to be the best year for economic growth since 2006. As a result, the Federal Reserve is a lock to raise rates by a quarter-point in September, and there is a 70 percent chance that they will do so again in December to cool down growth and prevent inflation from taking hold. But plenty can change before that. The biggest immediate threat comes from the rapidly escalating trade war we are in.

The most likely outcome of rising trade tariffs is a premature pause in the current interest rate rising cycle. A trade war will cause business demand for physical plant, equipment, and employees to contract due to heightened economic uncertainty. Trade wars will also cause consumer demand to lessen due to rising unemployment, higher prices, and falling consumer confidence, exacerbated by a decline in equity values. While such a slowdown would not be expected to be that large, it would still slow GDP growth and interest rate increases.

If, however, the hit to GDP is bigger than anticipated, because the quantity of imported goods facing steep tariffs rises substantially, rates could be reduced to ward off a possible recession. That would only occur if other factors came into play, as the current $50 billion in products facing tariffs along with any retaliatory actions by other nations is not nearly large enough to meaningfully reduce GDP, let alone drive us into recession.

The bigger fear is that a trade war has the opposite effect on monetary policy and forces the Fed to raise interest rates. If this occurs, it would be very destructive to both Main Street and Wall Street. For this to happen, the economy would need to experience a series of strong negative supply shocks. It might happen like this: global trade conflicts quickly escalate, significantly driving up the cost of many imported goods as well as domestically-produced substitutes.

While the chances of seeing rates rise to ward off a rise in inflation expectations is highly unlikely, it is a worst case-scenario for both the economy and financial markets. This is because it offers a combination of faster inflation, weaker growth, and tighter monetary policy. My baseline is that the impacts of rising tariffs and protectionism are too limited to meaningfully alter the course of monetary policy. But, in the fog of (a trade) war, things inevitably go awry just think of Harley-Davidson’s unexpected decision to shift to offshore manufacturing and adversaries respond in ways not anticipated; be prepared.