Investors are celebrating easing trade tensions between the US and China this week, but one former central banker warns that it could derail monetary policy.
To Bill Dudley, the former president of the New York Federal Reserve, this week’s tariff de-escalation could create more headaches for the Fed, and cause it to mistime interest rate cuts.
If officials wait too long and the economy stumbles into a recession, this would force them to cut rates by 200 to 300 basis points, he wrote in Bloomberg. And yet, the latest trade deal, which dials back tariffs for 90 days, could compel the Fed to hold back on taking action until the impact of the trade war is clearer.
“They have to wait, and because they are waiting, they’re probably ultimately going to be late,” Dudley reiterated in a separate Bloomberg TV interview. “But it’s not the Fed’s fault. I would behave exactly the same way in this set of circumstances.”
Though stocks are enjoying a streak of gains thanks to trade optimism, few economists expect improving relations to completely reverse the risk of tariff-fueled inflation. Even if duties come down, tariff rates are still high enough to spur price growth this year.
Investors should also understand that the US-China deal doesn’t mean the trade war is over: instead, it has diminished reciprocal rates to more digestible levels for 90 days to allow for negotiations. In other words, the pause only extends uncertainty, it doesn’t kill it, Dudley wrote.
Dudley cited that the average effective tariff rate will likely end up at 17.8%, enough to increase price levels and unemployment by 1.7 and 0.35 percentage points, respectively.
Both estimates are the opposite of what the Fed wants. In the near term, Dudley expects that it will have to hold off and remain patient, keeping an eye on inflation expectations — cutting too early might support economic growth, but it risks exacerbating price growth.
“Being patient, though, also entails risks,” he wrote. Rising unemployment could lead to more layoffs as spending slows, eventually precipitating a recession. The Fed will know its late if it’s responding after a sizable unemployment rate increase, Dudley told Bloomberg TV.
“It probably won’t get much clarity on inflation, growth and trade policy until September. If at that point it needs to reduce rates, it’ll have to move aggressively to arrest the deterioration in the labor market — especially given that the tariff-induced supply shock will undermine the effectiveness of monetary policy,” he wrote.
“If the US enters a recession, I’d expect rate cuts of 200 to 300 basis points.”
