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Fed sees GDP hit from trade war outweighing fleeting inflation

A trade war would leave the US Federal Reserve having to decide between battling weaker economic growth or rising prices. Which one it focuses on already looks pretty clear.

[NEW YORK] A trade war would leave the US Federal Reserve having to decide between battling weaker economic growth or rising prices. Which one it focuses on already looks pretty clear.

President Donald Trump's administration has proposed tariffs on imported steel and aluminum, from which a number of US allies would be exempt, and has threatened to slap additional measures on as much as US$150 billion of Chinese goods.

Higher and broader tariffs would raise the prices of those imports, potentially fanning US inflation, while reducing economic activity by sapping confidence and tightening financial conditions.

Minutes of the US central bank's March 20-21 policy meeting, published Wednesday, showed "a strong majority of participants viewed the prospect of retaliatory trade actions by other countries, as well as other issues and uncertainties associated with trade policies, as downside risks for the US economy".

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For Fed officials, those concerns seem to far outweigh the one-time increase in prices that tariffs would bring. After all, the effect on inflation would be similar to that of surging oil prices in 2011 as well as the subsequent collapse in 2014: that is, as they like to say, a "transitory" hit with few implications for interest rates.

"So far, it's not clear that it will make a large-enough difference to materially impact our policies," Mark Wright, director of research at the Minneapolis Fed, said in an interview.

"The impact on inflation is likely to be a one-off, so we would not expect it to flow through into inflation in the medium to longer term. The biggest concern for us would be its effects on the economy."

Dallas Fed researchers estimated in an April 4 analysis that the tariffs as proposed could reduce US gross domestic product by a quarter-percentage point over the long run, while a more full-blown trade war - involving both the European Union and China and a much wider range of imports - could reduce GDP by 3.5 per cent.

It's a hard question to pin down with much precision, though. Part of the problem is that the workhorse models the Fed relies on the most to prepare its forecasts are heavily oriented toward the domestic economy, while the components within them that address international linkages are less sophisticated.

This may partly reflect the one-way nature of trade policy over the past several decades - the backdrop against which these models have been refined - which has been characterised chiefly by multilateral liberalisation, as opposed to unilateral protectionism.

But a more immediate issue is the effect of heated US-China trade rhetoric on financial conditions, and in particular, equity prices. Changes in financial conditions tend to push in one direction when it comes to their impact on monetary policy - tightening almost always leads investors to bet on a slower pace of rate hikes.


"You have some of those intangibles that could negatively affect, say, consumer spending through the wealth effect. So, consumers may take a double hit because you've increased the cost of consumption and you've also reduced their net asset position," said Michael Gapen, chief US economist at Barclays Plc in New York.

"If the indirect effects happen - equity prices decline, and uncertainty rises - you may see a generalised slowdown in hiring, and a generalised slowdown in business spending that takes place across multiple industries and sectors," Mr Gapen said.

Some of that financial tightening has already happened. Over the past month, the S&P 500 Index of US stocks has fallen by about 5 per cent, while the number of Fed rate hikes priced into the futures market for the rest of the year has come down slightly.

But not much. Mr Gapen's team still expects Fed officials to authorise three more hikes this year following the one they voted on in March, because the impact of changes in trade policy doesn't look like it will be big enough to outweigh the effects of tax cuts and increased government spending announced in December and January.

Nor has the White House made its final decision on tariffs.

"One of the other possibilities we are looking at is that potentially this saber-rattling will not actually be implemented," Mr Wright said.

"And possibly the US will be able to extract larger concessions from China, in which case the effect ultimately could be a positive for the US economy, too."