Published:  01:26 AM, 12 September 2019

The latest escalation in the US-China trade war

The latest escalation in the US-China trade war

The US-China trade war unexpectedly escalated recently when President Trump announced a 15% tariff on $300 billion of Chinese imports that had thus far largely avoided becoming tangled up in the trade dispute.

In its countermoves, China suspended purchases of U.S. agricultural products and weakened the Chinese currency to make its exports more competitive. Financial markets sold off world-wide after China devalued the yuan. Emerging-market currencies plunged, equity markets dropped 3% or so in a day, and gold and the U.S. dollar soared as safe havens.

In earlier bouts in this trade fight, the impacted categories were further up the production pipeline. But, this time the consequences could be different. More direct consumer exposure gives this round of tariffs the capacity to more meaningfully impact U.S. inflation and consumer spending than earlier rounds did. The latest trade action may simply have pulled too many straws from underneath market and business confidence. The base has become steadily more fragile with a lengthy disruption to trade flows undermining global growth prospects.

The higher prices that importers will pay means either higher prices for U.S. consumers or squeezed margins for businesses. The extent to which the tariffs impact inflation will depend on a number of factors. Do importing U.S. firms absorb the additional cost of tariffs, leaving them with lower margins and profits? Or do they pass tariff costs on to consumers?

For starters, businesses may choose to absorb the cost of tariffs rather than pass them on to consumers. If businesses view the higher tariff rate as temporary, or fear consumers would scale back purchases significantly if the additional costs were fully passed on, they may absorb some of the tariffs via lower margins. This might not be an option for some businesses that are already locked into price contracts. Companies importing goods from China may also put pressure on their suppliers, reducing the starting value of goods subject to the higher tariff rate.

At the same time, a trade war would have negative implications for global growth and therefore support the value of the dollar, reducing import-price inflation. Even if the full cost of tariffs were to be passed on and consumer demand was unfazed, the impact to inflation would be fairly minimal given that about two-thirds of consumer spending goes towards services. As far as the consumers are concerned, they will initially allocate more for goods purchases and will either need to cut back spending for services or reduce their saving rate.

How much of an increase to inflation might occur? Consensus estimates show that the latest round will add a little over 0.1 percentage point to the year-over-year rate of CPI inflation. That may seem small, but goods make up only a fraction of the components that comprise the inflation basket. Specifically, about 75% of the core CPI is comprised of services, which are by and large insulated from tariffs.

Admittedly, the potential for major tariff increases on the bulk of Chinese imports raises the prospects of inflation at a time when the Fed continues to fall short of its inflation goal and needs every tenth it can get. That said, tariffs would represent a one-time shift in the level of prices, making the boost to inflation transitory. Eventually, though, the hit to confidence from higher prices for goods or sustained market turmoil could weigh on consumer confidence and ultimately spending as well.

The U.S. Federal Reserve has clearly been worried about global headwinds to the economic outlook, particularly as it relates to trade policy. The latest escalation in the trade war gives more reason for the Federal Reserve to be concerned about downside risks. The indirect effects on business and consumer confidence, corporate profits and investment are more reasons for the Federal Reserve to be concerned about the downside risks to the U.S. economy.

The direct impact still looks to be manageable as though consumer spending power will be reduced, the impact to the pace of spending should be fairly minimal. The indirect effects on business and consumer confidence, corporate profits and investment, however, give more reason to be concerned. With no end in sight to trade tensions, the resulting uncertainty could pressure the Federal Reserve to consider more interest-rate cuts in the coming months.

At stake in this trade war are the rules for global trade in a world order upended by China's rapid rise, and both sides are keen to project an image of strength. The longer the dispute lingers, though, the greater the risk of economic fallout for both countries, along with prolonged uncertainty for global equity markets. An eventual trade pact could give the U.S. and China momentum and a possible key to rapprochement on a number of other disputed issues.

Besides the US-China trade spat, there are also other trade related issues that may affect the global economy. The U.S. has not removed threats of auto tariffs on Europe and Japan, with a decision expected in November. And, a WTO decision favouring the U.S. on EU Airbus subsidy practices means another tariff strike is waiting in the wings.

The EU-U.S. trade relationship is larger than that with China. So, even if a deal emerges in short order with China, the global strain will persist on Europe and other regions. For instance, India also recently came under retaliatory fire from the U.S., and other Asian markets, e.g., Vietnam, have been warned. These are just the actions on countries known at this time. Few businesses and market participants would have anticipated the broad tariff threat placed, and subsequently removed, on Mexico a few months back in an attempt to address border security issues.

As far as China is concerned, they will continue to provide monetary and fiscal policy support for the economy as long as trade tensions persist and the tariffs remain in place. There had previously been some reports that policymakers were considering dialing back the degree of policy support, but recent tariff increase suggests authorities will maintain a steady stream of support for the Chinese economy.


The writer is a politician and columnist. He is presently serving as the Director General at Bangladesh Foundation for Development Research 

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