Why Trump’s trade war will unleash a wave of interest rate cuts
The likes of Andrew Bailey, Jerome Powell and Christine Lagarde probably thought the drama was over.
After an era dominated by Covid bailouts and rampant inflation, the central bankers would have been hoping for a few years of calm and steady economic growth.
However, Donald Trump has changed all of that by unleashing a barrage of global tariffs, ramping up American import duties to their highest level in more than a century.
The consequences of the president’s trade war are clear, with rattled economists slashing growth forecasts and increasing their expectations of a global recession.
It couldn’t come at a worse time for particularly indebted governments, as calls grow for policymakers to borrow more to spend on benefits, healthcare and defence.
Now they will need to prop up their economies too. And this is where the central banks come in.
Martin Weale, a former member of the Bank of England’s Monetary Policy Committee (MPC), says that a week ago he would have thought persistent inflationary pressures would have prevented Threadneedle Street from cutting interest rates further next month.
However, that is no longer the case. He now suspects the MPC will cut rates to kickstart growth, despite the risk of tariffs reviving the battle against inflation.
“They may go back into the sort of mode that was very much demonstrated in the pandemic,” he says. “When it looks as though demand is weak, you ease monetary policy.”
Willem Buiter, another former MPC rate-setter, thinks the stronger pound will help the Bank to ease rates, while falling oil prices will also strengthen the argument.
“The global economy, including the UK, will experience slower economic growth as a result of the tariff aggression announced on Trump’s ‘liberation day’,” he says.
“With sterling likely to strengthen vis-à-vis the US dollar and to weaken vis-à-vis the euro, there will at most be a mild inflationary impact [from] the trade war. I expect the Bank of England to cut Bank Rate slightly more quickly as real economic activity weakens.”
He expects four more cuts to take the base rate to 3.5pc, though “if the trade war is more intense, temporary additional cuts in Bank Rate to below 3.5pc are likely”.
The day before Trump announced his tariff plans, markets anticipated two more rate cuts from the Bank of England this year. Now they expect three, and perhaps another one early next year.
Similar predictions are also appearing in the eurozone and the US.
The difficulty is working out how far officials can cut interest rates to support growth without setting off an inflationary spiral.
Olivier Blanchard, former chief economist at the International Monetary Fund, says that while it’s too early to tell how things will play out, policymakers are likely to be more concerned about ensuring their economies stay afloat than fighting price rises.
“Surely the risk of a world recession has substantially increased, and with it [the chance of getting] low rates,” he says. “I think the recession will dominate whatever inflation concerns may arise.”
Investors are betting on faster rate cuts around the world, particularly in Europe, where Goldman Sachs believes it will not take much to tip the bloc into recession.
Markets are pricing in three more eurozone rate cuts between now and September, with the European Central Bank’s (ECB) next move increasingly likely to be a cut in two weeks’ time to 2.25pc and 1.75pc by the autumn.
Goldman said there was a one-in-three chance that rates could fall even further, depending on how quickly the outlook deteriorates.
Peter Praet, who served as chief economist at the ECB for almost a decade, is betting on borrowing costs coming down further.
“All data are supportive of a cut,” he says. “In its own logic of data-driven decisions, the ECB should cut. One can add that the negative impact of extremely high uncertainty on demand will reinforce the case.
“Admittedly, it will have to monitor potential upwards price pressures from protectionism, but such risk should not lead to policy paralysis.”
Praet warns that central banks should stand ready to respond to more economic shocks. “I see another cut in June, but beyond that, I would be more careful as extreme situations can unfold.” He is unsure when things will settle down: “The economy will not be in equilibrium for a while.”
The US Federal Reserve has a slightly different dilemma.
Ensuring the world’s biggest economy isn’t running too hot or too cold is difficult even in normal times.
But it now has the unenviable task of trying to keep a lid on price rises, whacked up by tariffs adding an extra tax on consumers, while also attempting to ward off a recession.
History suggests that the Fed cuts aggressively during downturns.
Chris Iggo, at Axa Investment Management, believes this will be the roadmap this time as well. “I don’t enjoy contemplating a global recession and equity bear market – my pension pot is in reach and I don’t want it to be diminished,” he says.
“Yet I can’t conclude a happier outcome when the US administration has no empathy with the rest of the world and is prepared to use strong-arm and barely believable tactics to get what it appears to think will be good for Americans.”
Not everyone agrees. Dame DeAnne Julius, a founding member of the MPC, does not expect anything like the four US rate cuts the market is currently pricing in.
After all, the mistakes the Fed made in failing to tackle persistent inflation are still visible in the rear-view mirror. “The Fed will be very concerned about letting inflation spike up again, and so I don’t think they’ll be cutting rates, even if the economy slows,” she says.
Lower rates might superficially sound good for borrowers, but they are unlikely to compensate for the pain of slower growth.
Andrew Goodwin, at Oxford Economics, says the move in markets means the Chancellor can expect more headroom than at the Spring Statement.
However, he adds: “When the Office for Budget Responsibility comes to update its forecasts, I suspect the impact of changes in financial market pricing will be outweighed by changes to the broader economic forecast and by the need to increase defence spending beyond 2.5pc of GDP.”
This may just be the start of the chaos, as policymakers try to track and predict the effects and counter-effects of the trade war.
It is hard enough for central bankers to work out how to react just to Trump’s tariffs in isolation, but they are not the only factor in play.
China has responded with border taxes of its own, the EU is considering retaliation and Trump himself is still deciding what to do about more industries, such as pharmaceuticals, which have so far escaped tariffs. On top of that, the capricious president sometimes goes back on his plans without warning.
The Bank of England has until May 8 to decide what to do.
That is a relief, says Weale: “Given the rate at which Trump changes his mind – he has said he is not going to change his mind on these tariffs, but he might change his mind on not changing his mind – I think it is lucky that they don’t have to make the decision this week.”