
The US-China trade truce doesn't solve the Fed's headache
The agreement between the US and China to roll back their respective tariffs for 90 days has led to renewed optimism that the worst of America's trade wars is over. I'm not seeing the 'breakthrough": There's still plenty of scope for economic damage that the Federal Reserve will struggle to contain.
First, the rollback might not last and doesn't change the broad contours of the story. Tariffs will still be high, fueling inflation and stunting growth. The Yale Budget Lab estimates that the average effective tariff rate will be 17.8%, up from about 2.5% when President Trump started his second term. That's enough to increase the price level and the unemployment rate by about 1.7 and 0.35 percentage points, respectively.
Also Read: Tariff whiplash: The US truce with China offers hollow relief
Second, the 90-day pause merely extends the corrosive uncertainty surrounding the US administration's policies. This will lead businesses to delay purchase, investment and hiring decisions.
Third, the Fed will still face the difficult choice between fighting inflation and supporting economic growth. In the near term, it'll have to be patient, holding interest rates steady and watching inflation expectations—even as this raises the president's ire. As a result, it will probably be slow in responding to weakening in the economy.
The Fed has little choice. When it doesn't know which way the risks skew, it must wait for more information. Right now any major move would have only a 50/50 chance of a positive outcome.
The central bank's predicament is particularly difficult given that inflation has overshot its 2% target since 2021. This makes any attempt to prioritize growth fraught, because it increases the probability that inflation expectations will become unanchored, triggering an upward price spiral that would be hard to contain.
That's an asymmetric risk the Fed can't afford to take. When inflation expectations rose in the 1970s, it took punishingly high interest rates and a deep economic downturn to get them back under control.
Also Read: Will a US-China trade agreement work? Don't count on it
Being patient, though, also entails risks. As the economist Claudia Sahm has noted, weakness in the US labour market can also be self-reinforcing, as layoffs hit spending and engender more layoffs. Historically, the unemployment rate has tended to rise sharply after crossing the threshold of a 0.5 percentage point increase, leading to recession. Last year proved to be an exception, because the rise in unemployment resulted from labor force growth outpacing strong hiring. This time will be different: Hiring will slow, while deportations and a border crackdown have depressed labour force growth.
What, then, will the Fed do? 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.
Also Read: Powell versus Trump: Why Fed independence matters in times of turmoil
If the US enters a recession, I'd expect rate cuts of 200 to 300 basis points.
The Fed shouldn't be faulted here. In contrast to the pandemic, when it was too slow in responding to inflationary pressures (thanks in part to a flawed monetary policy framework), this time around it's grappling with the fallout of trade policies that are beyond its control.
One can only sympathize and hope that clarity about the proper course emerges soon enough that the Fed can keep the economy afloat. ©Bloomberg
The author is a Bloomberg Opinion writer.

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Economic Times
20 minutes ago
- Economic Times
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Mint
26 minutes ago
- Mint
How Trump's trade war is supercharging fast fashion industry
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New Indian Express
34 minutes ago
- New Indian Express
Markets open higher on Monday tracking positive global cues
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