US Fed: Trade war is the Big Fear

The prospect of a trade war poses “downside risks” to the US economy, which otherwise is poised to grow at a solid pace, the Federal Reserve said Wednesday.

While the Fed said the steep tariffs on steel and aluminum imports that President Donald Trump imposed last month would not on their own have a significant effect, the possibility of “retaliatory trade actions by other countries” could be harmful.

In the minutes of March 20-21 monetary policy meeting, when the Fed raised the benchmark interest rate for the first time this year, the Fed also cited “other issues and uncertainties associated with trade policies” as risks to the outlook.

“Participants did not see the steel and aluminum tariffs, by themselves, as likely to have a significant effect on the national economic outlook, but 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,” the minutes said.

Dallas Fed researchers estimated in an April 4 analysis that the tariffs as proposed could reduce U.S. 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 percent.

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 characterized chiefly by multilateral liberalization, as opposed to unilateral protectionism.

But a more immediate issue is the effect of heated U.S.-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.

The minutes showed Fed officials were confident inflation would return to their 2% target as tax cuts and increased government spending provide a boost to the economy. At his first press conference as Fed chairman, Jerome Powell said the committee expected this fiscal stimulus to affect the economy only starting in the second half of the year.

The minutes showed that Fed officials thought it may be appropriate to raise interest rates over the next few years faster than previously expected.

Fed officials saw room for improvement in the labor market, as most of their contacts around the country reported that wage growth was still slow.

Shortly after the minutes were released, stocks added to their losses, while gold fell.