Counting on Rate Cut?
President Trump continued to call on the Federal Reserve to cut interest rates this morning, via Twitter. This time, he cited the Chinese government’s plans to cut China’s rates and implied that a rate cut by the U.S. Fed would put an end to the trade war right away.
By lowering interest rates, he argues that the this will inject more fuel into the U.S. economy by lowering borrowing costs, which will boost spending and hiring by U.S. companies. It will also boost the stock market, as we have seen so far in 2019. By boosting the economy through lowering rates, the U.S. will be in a much stronger bargaining position relative to China since global investors will favor the U.S. and its stock market over China’s.
However, I dont think it solves the trade issue. It just deflects the problem while potentially weakening China, and forces its leaders to make concessions in the trade negotiations.
My thoughts on how the tariffs will affect both parties
There was never any doubt that Wall Street would suffer from a trade war. What was less clear at the outset was the impact that higher tariffs would have on Main Street.
Despite President Trump’s claim that the tariffs paid to the U.S. Treasury were “mostly borne by China,” the evidence suggests that close to 100% of the tariffs were, in fact, borne by U.S. companies and consumers.
The tariffs were absorbed by U.S. importers in the form of lower profit margins and by U.S. consumers in the form of higher selling prices. This does not mean that Chinese producers escaped unharmed. Imports of goods tariffed will gradually decrease as U.S. demand shifted away from China and towards domestically-produced goods and imports from other countries.
Of course, I would also like to make the point that this only work if Americans are paying the tariffs, AND that the tariffs is allowing American producers to sell at a higher than they could before tariff-free Chinese competition. Imagine if the Chinese absorb all the tariffs, they will not increase their price of their goods for the American buyers. American producers would not gain any leverage over the pricing of their products. The American consumers, not paying for any tariffs, will not have any reason to change what they buy, even more so if the price of Chinese goods are still competitive. Hence, all would be pointless if Americans are not paying the tariffs.
You might think that the decision to divert spending from Chinese goods to, say, Japanese goods would be irrelevant for U.S. welfare. However, a simple thought experiment reveals that this is not the case. If a 10% tariff raises the price of an imported good from $100 to $110 and the consumer buys this good from China, the consumer will lose $10 while the U.S. government will gain $10, implying no loss in welfare. However, if the consumer buys the same good, tariff-free, from Japan for $105. Then the consumer loses $5 while the government gets no additional revenue, implying a net loss in national welfare of $5.
What about shifting demand to domestic goods? When we consider the case where the consumer buys an identical domestically-produced good for example, $107, in order to avoid the tariff. The additional demand will boost GDP by $107. The consumer who bought the domestically-produced good will be worse off by $7, but wages and profits will rise by $107, leaving a net gain of $100 for the economy. This will boost the economy when unemployment is high in the country.
As a consumer, I would prefer to source for cheapest alternatives. Trump’s tariffs will only work if it is more economical to produce goods in the United States. This is where it gets more complicated as producers, seeking to avoid paying the tariff, will start to move towards countries poorer than China, like Vietnam. If this happens, it will definitely undermine Trump’s policies.
Beggar-thy-neighbor policies make more sense when there is high unemployment. This is a key reason why support for protectionism tends to rise when unemployment increases. Today, however, this is not the case as the U.S. unemployment rate is at a 49-year low.
We still do not see a very large effect of the tariffs. For now, the American economy remains strong, with rising wages and the lowest unemployment rate in 50 years. But with less trade, American jobs up and down the value chain that are seemingly unrelated to importing and exporting goods could suffer. Increasingly, it looks like this will become a permanent tool to protect the United States’ trade industry and reduce the large trade deficit.