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The possible implications of broadening tariffs

06744 CC Trader Talk V2

In the face of a high degree of political uncertainty surrounding Brexit and Italy’s current situation within the EU, there is also increased concern relating to the broadening of tariffs on imported goods from China and possibly Mexico by the U.S. administration. Nonetheless, such concern leaves investors with a dilemma of what lies ahead across global economies, assessing the possibility of whether a global recession is imminent or not.

In this regard the Federal Reserve (FED) is assessing the appropriate policy response in terms of this developing trade shock. The question to be posed, is whether the FED will view such shock as a contraction in demand, or otherwise as an adverse supply shock, which could result in an upsurge in consumer prices by a full percentage point.

In line with what happened in 1995, the FED might ignore inflationary risks arising from higher tariffs, and cut policy rates as an insurance against high rescission risks.

In 1995 the FED implemented a correction in monetary policy, by cutting interest rates after a sustained period of tightening. Today, investors are beginning to wonder whether the FED will once again have to ease its stance after raising rates four times in 2018.

It is key to note that there are number of parallels between the current situation and what happened in 1995. The FED justified its three rate reductions at that time by pointing to moderate price pressures. Policy makers today are even more concerned on the low level of inflation, which might result in a possible re-occurrence of the 1995 situation.

Nowadays, markets are viewing the trade war as global demand shock which will eventually reduce the overall output growth. In an attempt to mitigate a future slowdown in growth, interest rates should be reduced.

Until very recently, the FED has given an indication that a situation signifying a slowdown in the overall growth rate, a perception which might trigger policy easing in order to provide an insurance against downside risks to activity. This has been confirmed by Mr. Richard Clarida, the FED’s vice-chairman in a recent interview, whereby he insisted that while taking an initial view through the initial effects of higher tariffs, the FED will ensure that the economy will continue growing.

Mr. Clarida also pointed out that the imposed increases in tariffs should not be underestimated, whereby the underlying effects could prove to be substantial. Academic evidence has indicated that the initial set of tariffs on Chinese imports has had a larger than expected effect on US consumer prices, with little of the impact being absorbed by Chinese exporters or US wholesalers and retailers.

In the absence of outright recession, this action would remove much of the downside risk facing the equity market. In fact, historical evidence demonstrates that following the insurance cut implemented in 1995, the equity market surged upwards in the first six months following such policy undertaking.

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