How should the Fed respond to Trump’s tariffs?

The Trump administration has just blown up the global trading system. Now what?

Markets have dropped as investors, businesses and individuals scramble for answers. History is no guide: in the context of an integrated global economy, the US’s decision to pull up the drawbridge truly is unprecedented and — even on the highly implausible assumption that nothing changes — it will take years, if not decades, for the full impact of “liberation day” to unfold.

But where precedent fails, textbook models can help. The new tariffs amount to a negative supply shock — lowering output, raising prices and hurting demand. This means nothing good for the US or global economy and will force the Federal Reserve to make hard choices.

Ruchir Sharma argued yesterday that the Fed should hold firm to avoid further endangering its credibility, after it was damaged by its response to the post-Covid inflation surge. But there are also economic reasons for policymakers to be hawkish.

Adding up the shocks

The US may be a relatively closed economy, but it cannot emerge unscathed from its effective tariff rate rising by around 20 percentage points in less than three months (that is, according to an estimate by the Yale Budget Lab). Higher import prices will feed through to businesses, which will face higher production costs, and households, which will face higher sticker prices.

Higher production costs will lower output, while higher prices for consumer goods will weigh on real incomes. US households are no longer flush with savings or particularly keen to splurge in the same way they were in the wake of the pandemic. For this reason, household spending is likely to take a hit faster than it did in 2021 (the last time inflation surged).

Businesses facing lower profits and reduced demand will cut back on investment as well as spending. The administration is betting on manufacturers responding to the tariffs by increasing their production capacity within US borders.

But capital spending requires certainty, and certainty is in short supply in Trump’s America. Between the White House’s record of bluster, the rising likelihood of political pushback and the potential for bilateral deals, it will take a long time to persuade businesses that the new trade regime is here to stay — and that they should make investment decisions on its basis. Domestic capacity is unlikely to rise anytime soon, even if that’s what Trump says tariffs are designed to do.

In sum, while the negative demand effect of tariffs calls for easing at the margin, their positive price and negative output effects give policymakers reasons to keep the benchmark rate high — and to potentially raise it further.

An inflationary backdrop

The Fed will need to work out which of these effects will be dominant. That in itself is not obvious. But policymakers should also consider that, beyond tariffs, Trump’s economic policy agenda threatens to unleash numerous other inflationary forces on to the US economy. Four in particular stand out.

The first is fiscal policy. Republicans’ flagship initiative this year is the extension of Trump’s 2017 tax cuts. The House and the Senate are currently negotiating a budget resolution bill which they will need to agree on in order to unlock the reconciliation process. The House’s plan features much more significant offsetting spending cuts than the Senate’s. But under neither plan is the deficit set to fall. Even if tariffs raise revenues at the margin, the US’s fiscal stance is set to remain expansionary.

The second is the dollar, which has weakened since “liberation day”. Some analysts have suggested this indicates a looming confidence crisis in the US currency. While that is hard to prove conclusively, many of the Trump administration’s policies do seem specifically designed to discourage its use in global reserves. Indeed, an agreement to weaken the dollar in exchange for tariff relief was the putative basis of a much-discussed, but likely moot, “Mar-a-Lago accord”.

The debate over the greenback’s future may rumble on, unresolved, for months or even years. Its recent decline, however, will have immediate and very real effects, pushing up the prices of imports further.

The third is inflation expectations, which as Chris Giles noted last week, had already started to move upwards in some consumer surveys ahead of “liberation day”. The full effect of the tariff-driven import price surge will take some time to show up in the data. Nevertheless, with post-pandemic inflation in consumers’ recent memory, policymakers fear the public will be less likely to treat a new run-up in prices as merely temporary.

The fourth is immigration. Since taking office, enforcement officials have carried out brutal deportations, after the Trump administration expanded their powers to conduct raids on undocumented migrants. The White House wants to scare them into leaving the US of their own accord. Some surely will, while others will leave formal employment and enter the informal economy to minimise their chances of being detected. Whatever political plaudits Trump may accrue through this hardline approach, the economic effects are not to be celebrated. With illegal immigrants accounting for about 5 per cent of the labour force according to Pew data, a significant drop in their participation would tighten the labour market, creating upward pressure on wages.

For now, nothing in the data calls for easing. Inflation is still well ahead of the Fed’s 2 per cent target, while March’s payrolls report, released two days after “liberation day”, was quite a bit stronger than market expectations. While the labour market may roll over in the next few months, policymakers should not act in anticipation. Instead, they should only deliver the next rate cut when the data definitively shows a sustained increase in unemployment.

Trump vs the Fed

Trump has never had much regard for the Fed’s independence. He is likely to value it even less if his administration’s stagflationary policies require the central bank to maintain a tight monetary stance as the US economy weakens.

The jawboning tactics were out already on Friday, but they could get worse. In the coming months, the White House could step up its attacks on the Fed to shift the blame for tariff-driven inflation on to the central bank. Such a move would be highly disingenuous, and would require some seriously contorted economic reasoning. But that is unlikely to matter to the administration.

While Trump will have no qualms about putting the FOMC in an uncomfortable position, the Fed should not be cowed. It should remain guided by the pursuit of its dual mandate in light of the economic data — and it should not be afraid to be hawkish if required, irrespective of how the White House might respond.

What I’ve been reading and watching

The FT’s data journalists have put together a bunch of charts showing some of the many ways in which the US’s new trade regime is entirely unmoored from economic reality

Gillian Tett revisits the work of Albert Hirschman (of the Herfindahl-Hirschman Index) to make sense of Trump’s tariffs

Alan Beattie’s guide to what’s next for global trade — and Tej Parikh’s take on why this all might not last

For a longer read, I’m enjoying Evan Thomas and Walter Isaacson’s The Wise Men. It’s a collective biography of six foreign policy advisers to US presidents serving after 1945 — some household names, such as Dean Acheson and George Kennan, others not — and how their outlook shaped the US-led international order that Trump is now taking apart