Trump’s Trade War Could Collapse Interest Rates

Central Banks Forced to Act as US Trade Policies Threaten Global Economic Growth

The likes of Andrew Bailey, Jerome Powell and Christine Lagarde likely believed the turbulent economic period was drawing to a close. After several years dominated by unprecedented Covid-19 bailout programmes and the subsequent battle against rampant inflation, these central bankers would have been anticipating a welcome respite of calm, steady economic growth and normalising monetary policy.

However, Donald Trump has dramatically altered this trajectory by implementing a sweeping array of global tariffs, effectively increasing American import duties to their highest level in more than a century. The former president, now returned to office, has wasted no time in pursuing his protectionist agenda, much to the alarm of economists and policymakers worldwide.

The ramifications of the president’s aggressive trade war are becoming increasingly apparent, with nervous economists hastily revising growth forecasts downwards and raising their projections for the likelihood of a global economic recession. Financial markets have responded with predictable volatility, as investors scramble to reposition portfolios in anticipation of a more challenging economic landscape.

Terrible Timing for Indebted Governments

This economic upheaval could scarcely arrive at a more inopportune moment for particularly indebted governments across the globe. Many nations are already grappling with mounting pressures to increase borrowing to fund essential public services, including welfare benefits, healthcare systems and bolstered defence spending. The latter has taken on increased significance amidst growing geopolitical tensions.

Now, these same governments will need to devote additional resources to propping up their faltering economies. And this is precisely where central banks find themselves thrust once again into the spotlight, despite having hoped to take a more measured approach to monetary policy following years of extraordinary intervention.

Bank of England Recalibrates Its Approach

Martin Weale, who previously served as a member of the Bank of England’s influential Monetary Policy Committee (MPC), notes that his assessment has shifted dramatically in a matter of days. He reveals that merely a week earlier, he would have anticipated persistent inflationary pressures preventing Threadneedle Street from implementing further interest rate reductions in the coming month.

However, the rapidly evolving economic situation has fundamentally altered this calculus. Weale now suspects the MPC will prioritise growth by cutting rates, despite the inherent risk that tariffs could potentially reignite inflationary pressures that the Bank has worked so diligently to contain.

“They may go back into the sort of mode that was very much demonstrated in the pandemic,” he explains, drawing parallels to the Bank’s previous crisis response. “When it looks as though demand is weak, you ease monetary policy.”

Willem Buiter, another former MPC rate-setter with considerable influence in economic circles, believes that sterling’s relative strength will provide the Bank with additional leeway to ease rates. He also points out that falling oil prices will further strengthen the argument for monetary loosening.

“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 observes with evident concern. “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.”

Buiter’s projections are specific and sobering. He anticipates four additional rate reductions that would take the base rate down to 3.5 percent. However, he cautions that “if the trade war is more intense, temporary additional cuts in Bank Rate to below 3.5 percent are likely.” This suggests the potential for even more aggressive monetary easing should economic conditions deteriorate more severely than currently expected.

Market expectations have shifted dramatically in response to these developments. The day before Trump announced his far-reaching tariff plans, financial markets had anticipated two further rate cuts from the Bank of England this year. Now, they are pricing in three rate reductions, with the possibility of yet another early in the following year. This represents a significant shift in monetary policy expectations within an extraordinarily compressed timeframe.

Similar Patterns Emerging Globally

Similar recalibrations of monetary policy expectations are materialising across the eurozone and the United States, highlighting the truly global nature of this economic challenge. Central banks worldwide are grappling with essentially the same fundamental dilemma: determining how far they can reduce interest rates to support faltering economic growth without inadvertently triggering a renewed inflationary spiral.

Olivier Blanchard, who previously held the prestigious position of chief economist at the International Monetary Fund, acknowledges the uncertainty surrounding the ultimate economic impact of these trade policies. Nevertheless, he suggests that policymakers are likely to prioritise economic stability over inflation concerns in the immediate term.

“Surely the risk of a world recession has substantially increased, and with it [the chance of getting] low rates,” Blanchard notes with characteristic insight. “I think the recession will dominate whatever inflation concerns may arise.” This assessment suggests a fundamental reordering of central bank priorities in response to the growing threat of economic contraction.

European Central Bank Under Pressure

Investors are increasingly betting on accelerated interest rate reductions globally, with particular emphasis on Europe. Goldman Sachs, the influential investment bank, has issued a stark assessment suggesting that the eurozone stands precariously close to recession, with even modest additional economic shocks potentially sufficient to tip the bloc into negative growth territory.

Financial markets are currently pricing in three additional eurozone rate cuts between now and September. The European Central Bank’s (ECB) next monetary policy announcement, scheduled in just two weeks’ time, is increasingly expected to include a rate reduction to 2.25 percent, with further cuts anticipated to bring rates down to approximately 1.75 percent by the autumn.

Goldman Sachs’ analysis paints an even more concerning picture, suggesting there exists a one-in-three probability that rates could decline even further, contingent upon how rapidly the economic outlook deteriorates. This represents a remarkable shift in expectations compared to just weeks earlier, when many analysts were predicting a much more gradual easing cycle.

Peter Praet, who served as chief economist at the ECB for nearly a decade and thus possesses intimate knowledge of the institution’s decision-making processes, anticipates further reductions in borrowing costs across the eurozone.

“All data are supportive of a cut,” he states unequivocally. “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.”

Praet acknowledges the potential inflationary implications of protectionist policies but cautions against policy paralysis. “Admittedly, it will have to monitor potential upwards price pressures from protectionism, but such risk should not lead to policy paralysis.” This suggests a preference for decisive action despite the inherent uncertainties.

However, Praet also emphasises the need for central banks to maintain flexibility and readiness to respond to further economic disruptions. “I see another cut in June, but beyond that, I would be more careful as extreme situations can unfold.” His uncertainty regarding when economic conditions might stabilise is particularly telling: “The economy will not be in equilibrium for a while.” This assessment suggests an extended period of volatility and adjustment lies ahead.

Federal Reserve’s Unique Challenge

The United States Federal Reserve confronts a somewhat different, yet equally complex, dilemma compared to its European counterparts. Calibrating monetary policy to ensure the world’s largest economy maintains appropriate balance – neither overheating nor unduly cooling – presents formidable challenges even during relatively stable periods.

But now, the Fed faces the extraordinarily difficult task of attempting to contain price increases – potentially exacerbated by tariffs effectively imposing additional costs on American consumers – while simultaneously working to prevent a recession. This balancing act represents perhaps the most significant test for the institution since the global financial crisis.

Historical precedent suggests that the Federal Reserve typically implements aggressive rate reductions during economic downturns, prioritising growth and employment over short-term inflationary concerns. Many analysts anticipate a similar approach this time, though with important caveats given the unique circumstances.

Chris Iggo, a senior figure at Axa Investment Management, believes this historical pattern will likely be repeated despite the complexities involved. He expresses a personal stake in these outcomes while acknowledging the broader economic implications.

“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 confesses candidly. “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.”

Divergent Views on Federal Reserve Response

Not all economic experts share this assessment, however. Dame DeAnne Julius, a founding member of the Bank of England’s MPC and respected voice in international economic circles, expresses scepticism regarding market expectations of substantial US monetary easing. Current market pricing suggests approximately four rate cuts by the Federal Reserve, but Julius questions whether this accurately reflects the likely policy trajectory.

She points out that the Fed’s relatively recent missteps in addressing persistent inflation remain fresh in the minds of policymakers and continue to influence their decision-making framework. “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 argues, suggesting a more cautious approach than markets currently anticipate.

Mixed Implications for Borrowers

Lower interest rates might superficially appear advantageous for borrowers across various sectors, but economists caution that these benefits are unlikely to fully offset the negative consequences of slowing economic growth. This creates a complex picture for households, businesses and governments alike as they navigate the changing economic landscape.

Andrew Goodwin, a respected economist at Oxford Economics, suggests that shifting market expectations could potentially create additional fiscal headroom for the Chancellor compared to projections made during the Spring Statement. This might theoretically provide greater flexibility for government spending or tax adjustments.

However, Goodwin immediately tempers this assessment with an important caveat: “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 2.5 percent of GDP.” This suggests that any apparent fiscal benefits from lower borrowing costs could prove illusory once the full economic impact is accounted for.

Beginning of Prolonged Economic Turbulence

Many analysts fear this represents merely the opening phase of a potentially prolonged period of economic turbulence, as policymakers attempt to track, predict and respond to the cascading effects and counter-effects of an escalating global trade war. The complexity is magnified by the multidimensional and rapidly evolving nature of the situation.

Central bankers already face extraordinary challenges in calibrating their responses solely to Trump’s announced tariffs. Yet this represents just one element of a much broader and more complex economic picture. China has already implemented retaliatory border taxes, while the European Union is actively contemplating its own countermeasures. Meanwhile, Trump himself continues deliberating potential tariffs on additional industries, such as pharmaceuticals, which have thus far escaped his protectionist measures.

Further complicating matters is the president’s well-documented tendency toward policy unpredictability. Despite his emphatic declarations regarding the permanence of these tariff measures, historical precedent suggests the possibility of abrupt policy reversals without warning. This unpredictability introduces an additional layer of complexity for policymakers attempting to formulate appropriate monetary responses.

Critical Decision Point Approaching

The Bank of England has until 8 May to make its next monetary policy decision, a timeframe that Martin Weale considers fortunate given the volatile nature of the current situation.

“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,” Weale observes with a hint of wry humour that nevertheless underscores the genuine uncertainty confronting central bankers.

As financial markets continue adjusting to this new economic reality, households and businesses across the United Kingdom are bracing for the potential impacts on their financial wellbeing. While lower interest rates might provide some relief for borrowers, the broader economic slowdown threatens employment, investment and overall prosperity. The precise contours of this evolving economic landscape remain uncertain, but what appears increasingly clear is that the era of monetary policy normalisation has been abruptly interrupted, with significant implications for economic stability both domestically and globally.