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Fed could find itself in a policy Catch-22 if tariffs spike inflation

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Flags outside the Fairmont Royal York in downtown Toronto, Feb. 3, 2025. 

Andrew Francis Wallace | Toronto Star | Getty Images

A complicated scenario is emerging surrounding the tariff drama that could put the Federal Reserve in an uncomfortable Catch-22, unsure whether to use its policy levers to tame inflation or boost growth.

With many bridges to cross yet in President Donald Trump‘s efforts to use the levies as a tool both of foreign and economic policy, the central bank will have a delicate balance to strike.

Many economists expect the tariffs both to raise prices and shave the pace of gross domestic product, with the main question being a matter of degree on the extent of any need for Fed policy adjustments.

“Maybe you get that price shock and maybe it’s offset by the dollar going up vs. the currencies of the countries subject to tariffs. But just really the long-term effects tend to be negative for growth,” said Kathy Jones, chief fixed income strategist at Charles Schwab. “You put that combination together and it puts the Fed in a real bind.”

There are a lot of moving parts happening in the dispute Trump is having with China, Canada and Mexico, the three leading U.S. trade partners. As things stand now, threatened duties against Canada and Mexico have been postponed as the president negotiates with leaders of those governments. But the situation with China has quickly escalated into a tit-for-tat conflict that has markets on edge.

A different history

That tariffs cause higher prices is practically an article of faith for economists, though the historical record provides less certainty. The Smoot-Hawley tariffs in 1930, for instance, actually proved to be deflationary as they helped worsen the Great Depression.

When Trump launched tariffs in his first term, inflation was low and the Fed was raising rates as it sought a “neutral” level. A manufacturing recession ensued in 2019, though one that did not spread to the broader economy.

This time around, the targeted tariffs that Trump had previously used have been replaced by the threat of blanket duties that could change the monetary policy calculus. Schwab projects that the tariffs at full strength could cut 1.2% off GDP growth while adding 0.7% to core inflation, pushing the latter measure above 3% in the months ahead.

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Broader tariffs “have both more price impact and more growth impact down the road,” Jones said. “So I could see [the Fed] staying on hold longer, with the threat of tariffs hanging over the market and maybe seeing these price increases and then having to pivot to easing later in the year, or next year, or [whenever] that growth impact shows up.”

“But they’re definitely in a tough spot right now, because it’s a two-sided coin,” she added.

Indeed, markets largely expect the Fed to hold tight for at least the next several months as policymakers observe the reality against the rhetoric on tariffs, along with looking for the impact from a full percentage point of interest rate cuts in the final four months of 2024.

If any of the parties blink on tariffs, or if they are less inflationary than thought, the Fed can go back to focusing on the employment side of its dual mandate and pivot away from inflation concerns.

“They’re very comfortably on hold right now, and the back and forth on tariffs won’t impact that, especially since we don’t even know what they’re going to look like,” said Eric Winograd, director of developed market research at AllianceBernstein. “You’re talking multiple months before this will meaningfully impact their thinking.”

‘A lot of uncertainty’

Winograd is among those who think that while tariffs could result in one-off boosts to some prices, they will not generate the kind of underlying inflation that Fed officials look at when making policy.

That matches some of the recent statements from Fed officials, who say that tariffs are likely only to affect their decision-making if they generate a full-blown trade war or somehow contribute to more fundamental supply or demand drivers.

“There’s a lot of uncertainty about how policies unfold, and without knowing what actual policy will be implemented, it’s just really not possible to be too precise about what the likely impacts are going to be,” Boston Fed President Susan Collins told CNBC in an interview on Monday. From a policy perspective, Collins said her current stance is to “be patient, careful, and there’s no urgency for making additional adjustments.”

Market pricing is still pointing to a likely Fed rate cut at the June meeting, then possibly one more quarter percentage point reduction in December. The Fed last week opted to hold the federal funds rate steady in a range between 4.25%-4.5%.

Winograd said he sees a scenario where the Fed can cut two or three times this year, though not starting until later as the tariff situation plays out.

“Given how insulated the U.S. economy generally is from trade frictions, I don’t think it moves the Fed needle very much,” Winograd said. “The market is presuming too mechanical of a reaction function from the Fed where if they see inflation go up, they have to respond to it, which simply isn’t true.”

Economics

China targets U.S. services and other areas after decrying ‘meaningless’ tariff hikes on goods

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Dilara Irem Sancar | Anadolu | Getty Images

China last week announced it was done retaliating against U.S. President Donald Trump’s tariffs, saying any further increases by the U.S. would be a “joke,” and Beijing would “ignore” them.

Instead of continuing to focus on tariffing goods, however, China has chosen to resort to other measures, including steps targeting the American services sector.

Trump has jacked up U.S. levies on select goods from China by up to 245% after several rounds of tit-for-tat measures with Beijing in recent weeks. Before calling it a “meaningless numbers game,” China last week imposed additional duties on imports from the U.S. of up to 125%.

While the Trump administration has largely focused on pressing ahead on his tariff plans, Beijing has rolled out a series of non-tariff restrictive measures including widening export controls of rare-earth minerals and opening antitrust probes into American companies, such as pharmaceutical giant DuPont and IT major Google.

Before the latest escalation, in February Beijing had put dozens of U.S. businesses on a so-called “unreliable entity” list, which would restrict or ban firms from trading with or investing in China. American firms such as PVH, the parent company of Tommy Hilfiger, and Illumina, a gene-sequencing equipment provider, were among those added to the list.

Its tightening of exports of critical mineral elements will require Chinese companies to secure special licenses for exporting these resources, effectively restricting U.S. access to the key minerals needed for semiconductors, missile-defense systems and solar cells.

In its latest move on Tuesday, Beijing went after Boeing — America’s largest exporter — by ordering Chinese airlines not to take any further deliveries for its jets and requested carriers to halt any purchases of aircraft-related equipment and parts from U.S. companies, according to Bloomberg.

Having deliveries to China cut off will add to the cash-strapped plane maker’s troubles, as it struggles with a lingering quality-control crisis.

In another sign of growing hostilities, Chinese police issued notices for apprehending three people they claimed to have engaged in cyberattacks against China on behalf of the U.S. National Security Agency.

Chinese state media, which published the notice, urged domestic users and companies to avoid using American technology and replace them with domestic alternatives.

“Beijing is clearly signaling to Washington that two can play in this retaliation game and that it has many levers to pull, all creating different levels of pain for U.S. companies,” said Wendy Cutler, vice president at Asia Society Policy Institute.

“With high tariffs and other restrictions in place, the decoupling of the two economies is at full steam,” Cutler said.

Targeting trade in services

China is seen by some as seeking to broaden the trade war to encompass services trade — which covers travel, legal, consulting and financial services — where the U.S. has been running a significant surplus with China for years.

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Earlier this month, a social media account affiliated with Chinese state media Xinhua News Agency, suggested Beijing could impose curbs on U.S. legal consultancy firms and consider a probe into U.S. companies’ China operations for the huge “monopoly benefits” they have gained from intellectual-property rights.

China’s imports of U.S. services surged more than 10-fold to $55 billion in 2024 over the past two decades, according to Nomura estimates, driving U.S. services trade surplus with China to $32 billion last year.

Last week, China said it would reduce imports of U.S. films and warned its citizens against traveling or studying in the U.S., in a sign of Beijing’s intent to put pressure on the U.S. entertainment, tourism and education sectors.

“These measures target high-visibility sectors — aviation, media, and education — that resonate politically in the U.S.,” said Jing Qian, managing director at Center for China Analysis.

While they might be low on actual dollar impact given the smaller scale of these sectors, “reputational effects — such as fewer Chinese students or more cautious Chinese employees — could ripple through academia and the tech talent ecosystem,” he added.

Nomura estimates $24 billion could be at stake if Beijing significantly step up restrictions on travel to the U.S.

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Travel dominated U.S. services exports to China, reflecting expenditure by millions of Chinese tourists in the U.S., according to Nomura. Within travel, education-related spending leads at 71%, it estimates, mostly coming from tuition and living expenses for the more than 270,000 Chinese students studying in the U.S.

Entertainment exports, encompassing films, music and television programs, accounted for just 6% of U.S. exports within this sector, the investment firm said, noting that Beijing’s latest move on film imports “carries more symbolic heft than economic bite.”

“We could see deeper decoupling — not only in supply chains, but in people-to-people ties, knowledge exchange, and regulatory frameworks. This may signal a shift from transactional tension to systemic divergence,” said Qian.

Can Beijing get more aggressive?

Analysts largely expect Beijing to continue deploying its arsenal of non-tariff policy tools in an effort to raise its leverage ahead of any potential negotiation with the Trump administration.

“From the Chinese government’s perspective, the U.S. companies’ operations in China are the biggest remaining target for inflicting pain on the U.S .side,” said Gabriel Wildau, managing director at risk advisory firm Teneo.

Apple, Tesla, pharmaceutical and medical device companies are among the businesses that could be targeted as Beijing presses ahead with non-tariff measures, including sanction, regulatory harassment and export controls, Wildau added.

Shoppers and staff are seen inside the Apple Store, with its sleek modern interior design and prominent Apple logo, in Chongqing, China, on Sept. 10, 2024.

Cheng Xin | Getty Images

While a deal may allow both sides to unwind some of the retaliatory measures, hopes for near-term talks between the two leaders are fading fast.

Chinese officials have repeatedly condemned the “unilateral tariffs” imposed by Trump as “bullying” and vowed to “fight to the end.” Still, Beijing has left the door open for negotiations but they must be on “an equal footing.”

On Tuesday, White House press secretary Karoline Leavitt said Trump is open to making a deal with China but Beijing needs to make the first move.

“In the end, only when a country experiences sufficient self-inflicted harm might it consider softening its stance and truly returning to the negotiation table,” said Jianwei Xu, economist at Natixis.

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