Trump is making life very difficult for an old enemy

Jerome Powell has, not for the first time, found himself between a rock and a hard place. The US Federal Reserve Board chairman may, thanks to Donald Trump’s trade wars, have to choose whether to preside over a steep economic downturn or a renewed outbreak of inflation.

It didn’t have to be like this. When Trump re-entered the White House he inherited an economy that was growing more strongly than any other developed country’s, with strong productivity growth, low unemployment and an inflation rate trending towards the Fed’s 2 per cent target.

Trump’s erratic policies have the US on the road to a recession.Credit: AP

The question the Fed was grappling with then was whether, after cutting the federal funds rate three times last year, it would make two or three more cuts this year.

But Trump unleashed Elon Musk, who embarked on a savage but chaotic assault on US government agencies and their employees and then Trump himself, initially with his tariffs on steel and aluminium, then his tariffs on Canada and Mexico and now his tariffs on everyone the US trades with (and some it doesn’t), launched a full-scale global trade war.

Everyone but Trump and his less literate economic advisers knows that Trump’s tariffs, particularly the 104 per cent-plus tariffs he’s placed on China, will lower US economic growth and increase unemployment and inflation.

They’ll be highly dislocative and destructive, because he has given US industry and foreign exporters so little time to position themselves for them.

That’s reflected in the sharemarket, where the big sell-off continued on Tuesday. The US sharemarket has fallen more than 12 per cent in the week since Trump unveiled his new trade regime.

It’s also generated turbulence and volatility in the US bond market, with yields initially tumbling as investors rushed to the traditional global haven in times of risks. Over the past few days, however, there has been a sell-off of bonds and yields, which have an inverse relationship with bond prices, have spiked.

An issue of US government bonds (government debt) this week was met with tepid demand.

Perhaps bond investors are having second thoughts about the market’s “safe haven” status. A depreciation of the US dollar in the aftermath of Trump’s tariffs announcement suggests they might be shifting their gazes, and funds, to other markets like Japan, Germany and Switzerland.

Fed chair Jerome Powell has some big decisions to make.Credit: Bloomberg

They might also have an eye on Trump’s “big, beautiful, bill,” the Republicans’ budget bill that’s wending its way from the Senate to the House, stuffed full of tax cuts and spending cuts – far more of the former than the latter.

The Republicans are seeking an increase in the US debt ceiling from $US36 trillion ($60 trillion) (which the US has already reached, forcing “extraordinary measures” to keep the government operating) to as much as $US41 trillion. The budget would, according to the Committee for a Responsible Federal Budget, add $US5.8 trillion to existing debt and deficits between 2026 and 2034.

If you’re a bond investor, that signals more issuances of US government debt, within an environment made volatile and uncertain by Trump’s tariffs and Musk’s ravaging of the bureaucracy, and one in which Trump has done a good job of antagonising the foreign investors who own about $US8.5 trillion, or 30 per cent, of the existing debt on issue.

Even if they (Japan, with $US1.06 trillion, and China, with $US759 billion, are the largest foreign holders) don’t sell down their existing holdings, they may not be keen to add to them while Trump is attacking their economies.

Less trade between the US and the rest of the world would also mean fewer US dollars in global circulation and fewer dollars with which to acquire US financial assets and help absorb the routine refinancing of the existing debt on issue, let alone a far bigger funding requirement. Fewer sources of buying means lower bond prices and higher yields.

Thus, Powell and his colleagues at the Fed, will need to think through and prioritise the various scenarios before them.

They know Trump’s policies will slow growth and increase inflation, but can’t be sure of the magnitude or duration of either the economic slump or the pick-up in inflation.

Powell himself said last week that, “while tariffs are highly likely to generate at least a temporary rise in inflation, it is also possible that the effects could be more persistent.”

They also know that the steepness of the sell-off on Wall Street and the volatility in the bond market could have unanticipated consequences.

There will be wealth effects, at a time when US consumer confidence is dropping rapidly, which will flow through to lower growth even before the actual impact of Trump’s tariffs shows up in higher prices.

There might also be disturbances within the arcane plumbing of the US financial system.

Some of the turbulence in the bond market is being attributed to a repeat of an episode that occurred in March 2020, when hedge funds scrambled to unwind the so-called “basis trade,” or a strategy of borrowing heavily to buy Treasury bonds and selling Treasury futures to profit from the usual small positive spread.

Those trades can be leveraged 50 to 100 times to generate low-risk profits unless, as there was in the early days of the pandemic and again over the past week, significant volatility. Then the hedge funds, experiencing margin calls from their lenders, dash for cash.

In 2020, the Treasury market – the world’s most important financial market – almost blew up before the Fed intervened and pumped more than $US1 trillion into the market in the second half of March.

The Fed will prioritise financial stability over everything else, so it will be watching the bond market very closely and will intervene if it believes there is a serious threat to stability developing within it.

Otherwise, if forced to choose between fighting renewed inflation or supporting economic growth and employment, the Fed will likely opt to combat inflation.

It is possible that the effects of Trump’s tariffs will be transitory, although the nature and breadth of the tariffs probably ensures a lengthy transition.

Everyone but Trump and his less literate economic advisers knows that Trump’s tariffs, particularly the 104 per cent-plus tariffs he’s placed on China, will lower US economic growth and increase unemployment and inflation.

The Fed has been there before, when it misjudged how transitory the impact of the supply chain shocks during the pandemic would be. As a result, the US inflation rate topped 9 per cent and it took a 5.5 percentage point increase in the federal funds rate to bring it back to the point where it is/was almost under control.

It is improbable that Powell and his fellow governors would risk making the same mistake again, even if their choice helps ensure that the US falls into recession.

They are aware that once inflation expectations become entrenched – and US consumers expectations of inflation have been spiking – it can develop into a self-reinforcing cycle with damaging long-term effects on the economy.

Regardless of whether the Fed raises or cuts rates, recession is possible, given how pervasive the impact of Trump’s tariffs will be throughout the US economy. Trump’s tariffs on steel and aluminium – and products containing them – are already having a deleterious impact on prices and activity.

While markets are now pricing in three or even four rate cuts this year, along with a 60 to 70 per cent chance of a recession, the Fed will probably risk Trump’s ire and investors’ wishful thinking and prioritise its core mandate of price stability.

Better a recession, even the harsh (and avoidable) one that Trump’s ill-conceived trade wars could induce, than the prospect of years of stagflation, or a prolonged period of low growth with high inflation that is one of the unpleasant but quite possible scenarios that the Fed would be contemplating.

The Market Recap newsletter is a wrap of the day’s trading. Get it each weekday afternoon.