US tariffs could cause policymakers to tackle the wrong economic challenge
Global Economic Uncertainty with Trump’s Inauguration
As Donald Trump prepares to take office with a pledge to “faithfully execute the office of President of the United States,” the world braces for a wave of economic and political uncertainty.
The return of Trump’s presidency brings with it proposals that could reignite inflation, coinciding with central banks celebrating their recent efforts to curb rising prices.
However, the danger lies in Federal Reserve Chair Jay Powell and his global counterparts relying on outdated strategies, which could lead to unintended economic consequences.
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Echoes of History in Today’s Challenges
Drawing a parallel with Franklin D. Roosevelt’s 1933 inaugural speech, where he famously stated that “the only thing we have to fear is fear itself,” Trump’s re-election stirs an atmosphere of uncertainty for investors and policymakers.
For central bank leaders such as Powell and European Central Bank President Christine Lagarde, the primary concern centers on inflation potentially spiking if Trump enforces his proposed tariffs, potentially undoing recent progress in controlling inflation and forcing a return to aggressive economic measures.
The Current Inflation Landscape
The Federal Reserve’s preferred inflation gauge, the core personal consumption expenditures (PCE) index—excluding energy and food—currently grows at an annual rate of 2.8%.
Goldman Sachs predicts this will align with the Fed’s 2% target by 2025, provided no disruptive new tariffs are introduced.
However, if Trump proceeds with proposed tariffs, such as 100% duties on imported cars or 60% levies on Chinese goods, inflation could climb significantly.
Even a 10% tariff on all imports could push inflation above 3%, triggering a domino effect of rising prices in economies like China, the Eurozone, and the UK.
The Impact of Supply Shocks
A new wave of global tariffs would create what economists term a “supply shock,” which disrupts production and supply chains, driving up prices.
Historically, central banks have adopted a passive stance during such events, waiting for inflationary pressures to subside naturally, as monetary policy offers no solutions to address supply disruptions directly.
Yet, in response to pandemic-induced supply chain issues and the energy crisis linked to Russia, Powell and his peers abandoned this traditional approach, opting instead for aggressive interest rate hikes, which they deemed necessary to combat inflation.
The Debate Over Effectiveness
Central bankers have lauded these measures as highly effective, claiming they prevented inflation from doubling. However, critics argue that other factors, such as the resolution of supply chain issues, played a much larger role in curbing inflation.
Studies suggest that only 20%-40% of the inflation decline in the U.S. can be attributed to higher interest rates, with the remainder resulting from external factors, including improved global supply conditions.
For example, supply chain pressures, as measured by the New York Fed, had already begun easing significantly by the time interest rate hikes commenced.
Challenges of Repeating Past Success
The recent success in taming inflation without triggering a recession, termed “immaculate disinflation,” may not be replicable in future crises.
Factors like strong labor markets and unexpected boosts in U.S. immigration and productivity were key contributors to this unique outcome.
These elements may not align again, making it risky for central banks to assume similar policies will yield the same results.
Preparing for the Next Shock
While Trump’s tariff policies may or may not materialize as aggressively as proposed, other potential supply shocks—arising from climate change, demographic shifts, or geopolitical tensions—remain a looming threat.
If central banks misinterpret recent successes and rely too heavily on forceful measures during supply-driven crises, they risk exacerbating economic instability rather than mitigating it.
source: reuters