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Trump’s Mexican tariffs may force Fed’s hand

By: Keith Wade, Chief Economist at Schroders

US President Donald Trump’s latest tariffs on Mexico and their effect on the US Federal Reserve (Fed)

We cannot be sure if President Trump’s Mexican tariffs are just part of his bargaining strategy, but it may get him the Fed rate cut he wants.

Interest rate expectations have moved significantly over the past week following Trump’s tweet that he was putting tariffs on Mexico. The market is now pricing in nearly three rate cuts of a quarter point each this year from the Fed. Only a week ago the market was pricing in just one.

Our view has been that the Fed would ease, but not until next year when there would be more evidence of a slowdown in activity.

Alongside the stalling in the US-China talks, the latest tariffs represent a ratcheting up of trade tensions and would hit growth, not just in Mexico but also in the US. Macro models suggest US Gross Domestic Product (GDP) would be some 0.7 percentage points weaker in 2020 than otherwise. This would put the US into recession according to our forecasts.

As always with Trump, one cannot be certain whether his latest move is part of a bargaining strategy and that ultimately he will not follow through. The problem for the Fed is that the market seems to have decided he means it. Consequently, it is more difficult for the Fed to push back without triggering considerable financial volatility.

Looking at the impact on the economy, higher tariffs hit trade but much of the near-term effect is likely to be through weaker confidence and falling equity markets; areas the Fed can influence.  

Chair Jerome Powell offered markets some reassurance yesterday when he said the Fed was monitoring the implications of the trade negotiations and would act appropriately to sustain the expansion. Meanwhile, there are signs that the economy is cooling and inflation remains low so there is little to stop the Fed making a precautionary “insurance” cut. This could come in late July but more likely September.

It remains to be seen whether Trump’s threats on tariffs achieve a resolution of the immigration crisis with Mexico, but it may get him the rate cut he wanted from the Fed.

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