Here’s a question for economy watchers: Is American economic policy in 2019 more like ouroboros, the ancient Egyptian symbol of a snake eating its own tail, or maybe more like an M.C. Escher painting in which a series of stairs wrap around a room in mind-bending ways?
Both seem like decent approximations of the strange ways in which trade policy, monetary policy and financial markets are intersecting this year. And never more so than this week.
On Wednesday, the Federal Reserve cut its main interest rate target, aiming to guard the American economy against damage from “trade uncertainty” and a slowing world economy, as the Fed chair, Jerome Powell, said at a news conference. But markets fell, with investors interpreting his comments to mean that the Fed won’t cut rates much more in the months to come.
Then on Thursday, President Trump announced a new round of 10 percent tariffs on $300 billion worth of China exports, suggesting that a trade war détente from earlier the summer may be coming to an end. That, in turn, caused a huge swing in bond markets that implied investors now do expect further interest rate cuts as the Fed tries to contain the trade-related damage.
Going back a bit further in time, the interplay between different aspects of economic policy becomes even more convoluted.
Early in the summer, trade talks between the United States and China broke down, and escalation of the trade wars seemed inevitable. The stock market fell, as the conflict seemed sure to hit corporate earnings. And bond yields fell, as investors became confident that the Fed would need to cut interest rates to contain the damage.
In late June, talks got back on track, but by that time Fed officials had largely made up their minds that it would be worthwhile to cut interest rates at least once to provide insurance against the slowing global economy.
Those plans, in turn, fueled a big stock market rally in late June and July, and most economic data has been solid in that time. Whatever the risks and downsides, the Fed’s shift toward lower interest rates seemed to have accomplished its goal of achieving financial conditions that will support continued economic growth.
“After simmering early in the year, trade policy tensions nearly boiled over in May and June, but now appear to have returned to a simmer,” as Mr. Powell summarized in his news conference Wednesday. President Trump turned the metaphorical stove back to high less than 24 hours after those words passed Mr. Powell’s lips.
That suggests the president and his trade negotiators believe they have downside protection against the risk that trade policies will cause any lasting damage to the economy or the stock market. After all, the Fed has very publicly shown that it views it as appropriate to cut interest rates to combat any slowdown related to trade wars.
There is always interplay between different elements of economic policy set by various parts of government. For example, the Fed’s practice is to take tax and spending decisions by Congress as a given and plug them into its models — and adjust its interest rate policies accordingly.
What’s different now is that Mr. Trump’s administration seems willing to weaponize that practice, offering no qualms about openly bullying the Fed while using its presumed reaction as a source of advantage in international negotiations.
Even as Mr. Trump is comfortable abandoning the norm that the president should not explicitly pressure the Fed, Mr. Powell appears to be obeying the tradition that the Fed should not try to use its power over monetary policy to twist the arms of elected officials.
It has worked out fine for Mr. Trump so far — the economy continues to grow heading into an election year, and while the stock market fell Wednesday after the latest trade news, the S&P 500 was down only 0.9 percent; it would surely have been down more if not for assumptions that further rate cuts were now more likely.
But it also creates a number of risks for the American economy, both in the short and longer term.
First, the Fed’s interest rate policies are blunt instruments. They seem to be more effective at generating big swings in asset prices than at fine-tuning the economy, and it would be easy for Mr. Powell and his colleagues to make a mistake — either by cutting interest rates too much, fueling inflation, or too little, allowing a slump.
There’s no modern precedent for having the world’s two largest economies, major trading partners, enter a trade war. And already the consequences have been more complex than one might have guessed.
The slowing Chinese economy has pulled down the price of oil, which has both lowered inflation in the United States and lowered capital investment by American energy companies. Even if the Fed is successful at boosting the overall stock market, lower rates probably won’t do much to help the industries and consumers directly damaged by tariffs.
Second, the monetary policy firepower that the Fed is using to try to offset the damage from trade wars may not be available if an economic slump caused by some other factor were to emerge. The central bank would have less room to stimulate the economy than it would if it were not deploying rate cuts now.
Finally, this pattern could do longer-term damage to the Fed’s credibility as an independent, credible central bank. The United States dollar is central to transactions around the world, a source of long-term geopolitical advantage. Confidence in the Fed is part of the reason. Global investors generally believe that the central bank will act with a long-term view, not based on the political needs of the current American president.
This leaves Mr. Powell in a pretty miserable spot. One way he could decisively break the cycle would be to abandon deeply held principles — threatening to ignore the potential damage to the economy from trade wars because he thinks the president’s policies will do damage over the longer term. That’s not the role for unelected officials like the Fed chief, or at least it isn’t supposed to be.
In this particular ouroboros, in other words, it sure seems like Mr. Trump is the mouth, and Mr. Powell is the tail.