Interest rates, stock prices, and commodity prices are all down sharply over the past week thanks in part to the escalation of the trade conflict between the U.S. and China. Against this backdrop, it is likely the Federal Reserve will continue cutting interest rates.
The Fed had good reason to lower the federal-funds rate at the end of July even without the latest trade ruckus. Slowing growth in China and Europe, the dwindling impact of fiscal stimulus, manufacturing weakness, and the continued bite of the housing slowdown all posed risks to the U.S. economy. Officials have also expressed concern about the longer-term inflation outlook, and market pricing on interest rates consistently implied the Fed had its rate target too high to sustain growth. Because of all this, it was not unreasonable to expect a modest series of tweaks to “sustain the expansion,” as Chairman Jerome Powell has put it.
Recent events give all the more reason to keep lowering rates. Shortly after the Fed announced it would reduce interest rates, President Donald Trump announced the U.S. would charge 10% tariffs on about $300 billion of imported Chinese consumer goods excluded from previous levies. According to Trump, the move was a response to the Chinese government’s failures to honor its commitments as well as its attempts to stall trade negotiations until after the 2020 elections.
Beijing’s response came Monday morning with the Chinese currency being allowed to move past the psychologically significant level of 7 yuan per dollar. The yuan has not been cheaper relative to the dollar since the beginning of 2008. Trump quickly accused the country of “currency manipulation,” and by the end of the day, the U.S. Treasury had officially designated China a “currency manipulator.”
It is important not to overstate the severity of these moves. So far, the decline in the yuan has been contained, with the People’s Bank of China noting its commitment to “keeping the [yuan] exchange rate basically stable at an equilibrium and adaptive level.” At the same time, the Treasury’s announcement is mostly bluster. The only concrete action, according to the press release, would be to “engage with the International Monetary Fund.” In its most recent assessment of the Chinese economy, the IMF had concluded China’s effective exchange rate was “at the same level as warranted by fundamentals and desirable policies.”
Still, the currency depreciation should offset much of the impact of Trump’s proposed tariffs on the dollar prices of Chinese goods. That may be good for American consumers, but irritating to anyone hoping tariffs would lead to changes in trading patterns.
At the same time, the cheaper yuan functions as China’s own reciprocal tariff on imports from the U.S.—and elsewhere. Unlike last October, when the Chinese government was trying to stabilize the yuan against a broad basket of currencies that all happened to be losing value against the dollar, the recent move seems to be a tactic to spread the impact of America’s tariffs to the rest of the world, particularly Europe, South Korea, and Japan.
Bo Zhuang, a China economist at research provider TS Lombard, argues the timing conveniently allows the Chinese government to “point the finger” at the U.S. while engaging in protectionist behavior to offset the impact of China’s debt overhang on its “domestic growth outlook.” At a time when Chinese businesses, households, and the government are relatively constrained in their ability to borrow, it should not be surprising that the government might want to support exports for the sake of jobs and incomes.
This is only going to make things worse for the global manufacturing industry, which had already been hurting thanks to the Chinese government’s efforts to replace foreign imports with domestic production. According to the Netherlands Bureau for Economic Analysis, world industrial production was roughly flat between October and May. Previous stalls in 2012 and in 2015 were associated with the euro crisis and the China-led commodity bust, respectively.
Surveys compiled since then by JPMorgan and IHS Markit indicate global manufacturers have entered a downturn thanks in large part to accelerating declines in export orders. The current readings, published last week, are at their lowest levels since the height of the euro area’s crisis in 2012. For American manufacturers, the situation is the worst it has been since 2009.
While manufacturing is not the economy, it plays a huge role in the business cycle because of its volatility. During the 2007-09 downturn, for example, about two-thirds of the total decline in U.S. gross domestic product was attributable to cutbacks in household spending on durable goods and business investment in new capital equipment net of changes in inventories and the trade balance. For perspective, consumer durables and business equipment together accounted for less than 15% of the total economy on the eve of the downturn.
The pressure on manufacturing helps explain why the Fed lowered interest rates last week and why it is likely to continue lowering rates. The danger, as Michelle Meyer and Alexander Lin of Bank of America Securities put it, is that “we end up with an ever-escalating trade war matched by an ever-lower fed funds rate.”
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