Back on May 18, Deutsche Bank’s Aleksandar Kocic explained why Fed cuts might make things worse given the interaction between the trade war, monetary policy, the economy and markets.
His reasoning was straightforward. Here’s the relevant quote:
An overly accommodative Fed could encourage further escalation of trade wars with more tariffs on one side and, at the same time, erode Fed’s credibility on the other. Further trade war escalation would act as a negative supply shock causing a higher price level ultimately forcing the US consumer to carry the costs of higher tariffs. In this way, temporary stock market stability becomes destabilizing with the economy suffering from higher inflation and lower output which does not have a proper monetary policy response.
In other words, if the Fed cuts rates thereby acquiescing to Donald Trump’s explicit demands that Jerome Powell help counteract easing from China and Europe, it could embolden the US president to delay a resolution to the trade war or even to escalate things further. As protectionist measures are left in place or are ratcheted up, the likelihood of tariff-related price pressures and deleterious growth effects increases. “Bad” inflation and slumping growth has no adequate monetary policy response. Rate cuts risk exacerbating inflation, while failing to cut rates risks worsening the growth slump.
Since Kocic laid out the problem, the idea that the Fed is poised to get roped into the trade conflict with the possible side effect of making things worse by emboldening Trump, has gathered adherents. Trump has, of course, made things worse by explicitly calling on the Fed to engage in competitive easing.
In the wake of the June Fed meeting and now the tentative trade truce struck in Osaka, markets are confronted with the same worry. The Fed has all but pre-committed to a July rate cut (the only question being whether it’s 25bp or 50bp) and markets are looking for 100bp worth of easing within a year.
At the same time, existing tariffs on Chinese goods remain in place and the new ceasefire includes no timeline for removing them.
This pretty clearly opens the door to a scenario where, with stocks at new record highs and the dollar seemingly poised to move lower, Trump believes he’s regained the upper hand. That increases the odds that he’ll eventually move forward with at least 10% duties on the remainder of Chinese goods.
In a note dated Sunday, BofA reiterates the quandary Deutsche’s Kocic pondered back in May.
“Although there was some de-escalation in Osaka, perhaps the biggest risk going forward is of a perverse feedback loop between the Fed’s attempts to support the economy and President Trump’s incentives to re-escalate various trade conflicts”, the bank writes, before spelling it out as follows:
In particular, suppose (1) the Fed is following a “risk management” approach, in which it tries to raise inflation by sustaining above-trend growth, and avoids disappointing the stock and bond markets, and (2) the Trump Administration only stops escalating the trade war if there are notable signs of pain in the economy or markets. If this “Powell Put” and “Trump Call” are strong enough, they could create an ever-escalating trade war matched by an ever lower funds rate (Chart 1). The stock market would be left in a range-bound “collar” trade, with its upside and downside capped by the trade war and the Fed, respectively.
It’s worth noting that Monday’s PMI data (which was weak across the board on a global scale) clearly indicates that the resumption of the trade war in May dealt a grievous blow to confidence. Weakness in the data makes the case for more accommodation from the Fed, which in turn could tempt Trump to reengage on the tariffs. That’s the perilous loop.
So, what can short-circuit it? Well, three things, according to BofA, all of which we’ve been over in these pages before.
First, the bank notes that the Fed “will not be able to fully offset an escalating trade war”. Specifically, BofA argues that “even lowering borrowing costs by 2% cannot make up for the risk of a 25% tariff”. Eventually, a recession would ensue.
Second, political considerations could intervene if the public (specifically Trump’s base) begins to see the effect of tariffs on consumer prices and revolts against the trade war.
Third, BofA essentially posits the “crazy like a fox” strategy, wherein, having secured the rate cuts he wants, Trump moves to strike a quick deal with China, thereby sending stocks into the stratosphere in 2020 ahead of the election.
If you ask BofA, that strategy is not a risk-free proposition. “Facing an economy that is even more likely to overheat, the Fed might have to quickly reverse course and start hiking, at the risk of damaging its credibility”, the bank warns.
Needless to say, if the Fed began to hike rates midway through next year with the economy hitting on all cylinders and stocks up another 20%, Trump would doubtlessly allege a vast conspiracy on the way to demoting Powell “by hook or by crook“, as Albert Edwards put it last week.