Rhetoric around the trade war appears set to deteriorate into recriminatory mudslinging following Donald Trump’s ill-advised decision to claim Beijing was “beaten so badly” in what were previously described as amicable negotiations between representatives from the world’s two largest economies.
Trump, it would appear, can’t resist the urge to couch everything in terms of competition and zero-sum games.
Meanwhile, China is accusing the US of “guarding trade in the name of IP protection.” Beijing’s state newspaper is blaming the US for the setback in the trade talks.
As detailed on Saturday evening, a move by the Trump administration to slap tariffs on all Chinese imports would have serious ramifications for US inflation, and the situation would be complicated further if the US were to impose auto tariffs predicated on the Section 232 probe.
It’s not entirely clear what all of this would mean for Fed policy. Obviously, a worst-case scenario that sees inflation pressures build materially as Trump goes “all-in” on the protectionist push would also see growth take a serious hit, leaving monetary policymakers to ponder the proper response to tariff-related price pressures and a deteriorating economic outlook.
In the near-term, any dollar strength that accompanies further escalations risks bringing the dollar liquidity shortage/squeeze story back to the fore. That narrative was already starting to work its way back into the financial news cycle (see here and here).
One worry being voiced by analysts is that Trump now believes his own story when it comes to the notion that the Fed, not the trade war, was the proximate cause of last year’s risk asset malaise. Consider this, from BofA:
There is also the possibility that the Trump administration does not believe that the trade war negatively affected markets. The issue is that when the markets were weak last fall, the trade war was escalating and the Fed was hawkish. During the recovery this year, trade tensions have cooled and the Fed has turned dovish. So the cause of the market moves is not entirely clear and it is possible that the President believes that the Fed, and not trade, was the real problem. This is what economists call an “identification problem.”
This is a question that continues to haunt market participants. Although it’s pretty clear that Jerome Powell’s “long way from neutral” communications misstep was the straw that broke the camel’s back, don’t forget that just 9 days previous (so, on September 24), tariffs on $200 billion in Chinese goods went into effect. Here’s a visual:
BofA goes on to note that according to their event study, both the trade war and the Fed “contributed similarly to both last fall’s selloff and the subsequent rally, until the latest trade shock.”
In Goldman’s analysis of the worst-case scenario for US inflation (highlighted in the first linked post above) the bank assumes 25% tariffs on all Chinese imports and the imposition of auto tariffs. In that scenario, Goldman sees a peak 0.9pp impact on core PCE and a potential 0.8% downside for US GDP (that takes into account a 10% slide in equities).
Using the same worst-case assumptions, BofA assesses the cross-asset implications. To wit:
Of course the most worrying scenario is a full-blown trade war. In this case we assume that the US and China end up imposing 25% tariffs on nearly all bilaterally-traded goods. There is no trade deal in the near term. We also assume escalation on the auto tariff front after talks with China break down. We even see a risk of a 20% tariff on all auto and parts imports with partial retaliation by impacted countries. We continue to view this scenario as very unlikely. There will be plenty of warning signs in the markets and the forward-looking data on the path to a trade war: we fail to see how the Trump administration would not be persuaded to back down at some stage, especially with the Presidential elections coming up next year.
With all due respect, saying something like “we fail to see how the Trump administration would not be persuaded to back down” assumes that the US president is a rational actor. That is not a safe assumption.
In any event, here is table from BofA which attempts to summarize what the bank believes the cross-asset implications would be for various outcomes. We’ll present it without further comment other than to draw your attention to the “risk of global recession” warning in the “Growth” column corresponding to the “Trade war” scenario.