The Fed Is Trump’s Secret Ally in the Trade War

In his various trade wars, U.S. President Donald Trump seems to have fewer and fewer allies. Early in his tenure, he slapped steel and aluminum duties on most of the world. He menaced the European Union and Japan with auto tariffs. He forced Mexico and Canada to sign a deal to rename the North American Free Trade Agreement, and then threatened Mexico with a new round of penalties unless the country did more to address immigration to the United States. South Korea only avoided new tariffs by signing a (mostly meaningless) new trade deal.

It is difficult to find a country, friend or foe, that has escaped Trump’s wrath. And even Trump’s fellow Republicans in the Senate have voiced skepticism about his latest tariff spat with Mexico and his plans for imposing duties on European cars.

But Trump has kept one key ally in his trade battles: the U.S. Federal Reserve.

Textbook economics teaches that tariffs make countries poorer by driving up prices, thereby reducing business competitiveness and cutting consumer purchasing power. The president and his advisors do not take that that idea seriously. Trump is, as he has tweeted, a “Tariff Man.” And many of his aides, including Peter Navarro and U.S. Trade Representative Robert Lighthizer, are long-time proponents of the idea that tariffs should play a major role in trade policy.

The Fed has helped sustain the economic growth that Trump points to as evidence that his tariffs are working.

Economists at the Fed, however, do read economics textbooks. And whereas Trump may think that “trade wars are good, and easy to win,” as he famously tweeted, the Fed believes the opposite—that they will drag down economic growth. This gap is excellent news for the president. Because the Fed believes that it should keep interest rates low to boost growth when the economy is slowing (so long as inflation is under control), it has refrained from raising rates over the past six months, in part to cushion the blow from the trade war. In doing so, it has helped sustain the economic growth that Trump points to as evidence that his tariffs are working.

The Fed has two mandates, established by law: to keep inflation and unemployment low. A year ago, on both these metrics, all signs pointed to a need to raise interest rates. The economy was in a decadelong expansion. Unemployment was touching historic lows. And the massive deficit-funded 2017 tax cut had stimulated the economy at a time when many economic models suggested that policymakers should be reducing stimulus to prevent inflation. Indeed, in 2018, inflation hit the highest level in more than five years. Surely, experts and investors assumed, the Fed would keep increasing interest rates to slow the economy and keep inflation contained.

One year and several tariff hikes later, things look rather different. It is understandable that the Fed believed it had to act. U.S. businesses and consumers alike are substantially exposed to trade. Consumers buy many things—from avocados to iPhones to cars—that are partially or wholly produced abroad. Businesses produce many goods using inputs from abroad. And they also sell abroad, making profits that help fund consumption in the United States. All these activities are made more difficult by tariffs.

Trump’s first tariff move, imposing duties of 25 percent on steel and 10 percent on aluminum in March 2018, was relatively minor. Steel and aluminum make up a small share of U.S. imports, and President George W. Bush had done something similar in 2002. The trade war with China, the threats to slap auto tariffs on Europe and Japan, and constant antagonization of Mexico are an order of magnitude more disruptive. On Friday, Trump agreed not to impose tariffs on Mexico. By Monday, he was tweeting about the prospect of new tariffs. China and Mexico are two of the United States’ largest trading partners. Taxing trade with them will force consumers to pay more and will force companies to rework complicated supply chains. None of this is good for the economy in the short run.

But rate cuts—a form of economic stimulus—can slow the bleeding. They also support the stock market, which is as afraid of Trump’s tariffs as the Fed. Yet this dynamic is dangerous. The more tariffs Trump threatens and imposes, the more the Fed cuts rates.  And that, in turn, encourages him to threaten yet more duties.

The Fed’s shift toward monetary easing matters not only in economic terms. It has crucial political relevance, too. The state of the economy will be a key determinant of the 2020 presidential election. If the economy is doing well, Trump will claim credit. If it is doing poorly, he will face blame. Every time the Fed signals that it will move to support the economy, it is also boosting the prospects of Trump’s reelection.

The Fed is simply doing its job. If Trump’s trade policies threaten to boost unemployment or inflation, the Fed is obligated to respond. But America’s monetary policymakers nevertheless find themselves in a bind. They are often described as being “independent” of politics. True, they are not taking orders from the White House. But they are being driven, in effect, by the president’s trade tweets. No one wants the Fed to let the economy slow unnecessarily, which would mean fewer jobs and lower wages. But the Fed’s alternative is hardly more satisfying: using monetary policy to mitigate the costs of tariffs and to keep the economy humming as Trump claims credit for his tremendous economic victories.