US-China trade war could push ECB to continue easing

Reuters

5 days ago

LONDON, July 31 (Reuters) - The impact of U.S. tariffs on world trade flows will reverberate in numerous ways for years to come, but a potential re-routing of Chinese exports to Europe could slow inflation there and heap pressure on the ECB for further monetary easing.
The European Central Bank appears to have convinced most people last week that the bar for more interest rate cuts in this cycle is quite high. Inflation is near its target, a tariff shock in the euro zone has likely been avoided following the bloc's deal with Washington this week, and a major German fiscal stimulus promises to stoke a 2026 euro zone upturn.
Money markets no longer fully price another rate cut in this cycle, and major financial houses such as Deutsche Bank now reckon the easing cycle is over.
But as Washington prepares its final list of tariffs for the world at large on Friday, there's another pressure for the ECB to consider.
In a blog published on Wednesday, ECB economists detailed, opens new tab how a major flow of Chinese trade away from the United States could lower euro zone inflation further next year, causing the central bank to significantly undershoot its 2% target.
Various models considered the potential impact of having higher U.S. tariffs on Chinese goods versus the levies on the rest of the world. The conclusion was that Chinese imports to the euro zone could rise 7%-10%, with Europe's already significant reliance on Chinese imports making it more likely it will absorb cheaper redirected goods.
Some 75% of all products imported by big euro zone countries already have at least one Chinese supplier, they point out.
Chinese authorities have pledged to support their exporters as they seek new markets at home or in third countries.
What's more, China's yuan has fallen almost 10% against the euro over the past six months, making Chinese imports to Europe even cheaper.
The direct disinflationary impact seems pretty clear before even discussing the effect on European companies of a new wave of lower-cost competition.
"With trade tensions between China and the United States reaching new heights, Chinese exports may be redirected to the euro area," the blog concludes. "In a severe scenario, this additional supply and the accompanying lower import prices could bring down euro area inflation by as much as 0.15 percentage points (next year)."
Smaller effects would persist through 2027, they added.
Given that the ECB already forecasts that headline inflation will be below its target next year at a rate of 1.8% and only rise to 2% in 2027, added deflationary pressure risks causing a bigger undershoot that may force the central bank to cut interest rates at least once more this cycle.
The ECB blog tallies with a column written by Bank of Italy economists, opens new tab last month entitled "The Great Wall of Chinese goods." It argues that a tariff-related diversion of Chinese exports to Europe could cut core euro zone inflation by 0.3 points over two years.
They highlight the fact that equipment and machinery such as batteries, lighting, and appliances, as well as electronic goods such as computers, televisions, and cameras, make up the lion's share of EU imports from China. And they show that the euro zone imported about $400 billion of manufactured goods from China, more than 20% of total imports to the bloc.
"The findings highlight how protectionism abroad can bring disinflation to open economies like the euro area," they wrote.
The studies concentrate solely on the exporting powerhouse that is China, but much higher U.S. tariffs are also being levied against some other BRICS nations, Brazil, India and South Africa.
Re-routing of goods from these countries to the EU may be a factor at the margins, exaggerating the disinflationary effect.
And demand in Europe for cheap imports may be boosted by the effects of higher government spending in the euro zone starting next year.
Whether the ECB should look through another period of sub-target inflation is then a big question. Further easing may do little to directly address diverted imports and may even stoke demand for them further. Moreover, the retreat of the euro in recent weeks might take some of the pressure off.
But with a singular inflation-targeting mandate unlike the Federal Reserve, the ECB may feel obliged to address persistent undershooting with more rate cuts.
With everyone now guessing about the wider fallout from the tariff war, it may be premature to assume the ECB is at the end of its easing road yet.
The opinions expressed here are those of the author, a columnist for Reuters
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