The Growing Threat of Protectionism

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President Trump Presses On

In his first week of official Presidency, Donald Trump has signed a wave of executive orders intended to demonstrate his commitment to keeping his election promises. While some of the policies will take longer to draft and implement, such as tax reform, others are taking immediate effect, including trade policy.

In one of the first key changes, President Trump pulled out of the Trans-Pacific Partnership, and although it had little chance of passing Congress and offered only small prospective gains to GDP, the loss is still symbolic.

High on the list of the new President’s priorities is re-negotiating NAFTA. Mexico & Canada account for around 30% of US trade and so will be a key focus for Trump. It is not known yet whether tariffs on Mexican and Chinese imports, which current stand at 35% and 45% respectively, will be levied. Indeed, more pressure is being applied, even on a firm by firm basis and protectionism is now looking likely to pose a bigger threat than first expected and is likely to weigh on growth while pushing prices higher.

Negative Effects of Trade Restrictions

Trade barriers will shrink import availability, reduce choices, push prices higher, weaken competition and could slow both innovation and productivity. Of the consumer prices likely to react first are those which change frequently and have a relatively high import content such as alcohol. If on the other hand, tariffs were imposed on raw materials a tariff could take longer to filter through the production chain and into consumer prices.

Higher prices will weigh on real incomes and consumption, and although some industries will do better, such as domestic car production, losses will be spread more widely as prices rise, capping consumption. In the political environment, large gains for small groups could pay off as losses can be spread more thinly.  With the economy at full employment, it is hard to see a net gain in output unless protectionist policies significantly raise US investment and therefore, capacity.

Lower output is actually more likely than higher output, especially if there are retaliatory trade restrictions leading to a trade conflict. In terms of gauging potential losses, the Peterson Institute have argued that protectionist policies could result in a recession. However, others have argued that losses would be more moderate such as only 0.5% of GDP. It mainly depends on the intensity of the actions and the extent of possible retaliation.

How Would This Affect the Fed?

Higher prices and lower growth would present a challenge for the Fed. A Fed rate hike would likely only be appropriate in response to higher prices if second round effects materialized. Risk premia, would likely be higher than now, but the currency effects are unclear, this is partly because some large holders of US treasuries could be caught up in a trade conflict with the US, and also because a competitive devaluation against USD could be a clear response to US tariffs.

If China exported less to the US as a result of trade restrictions, it might be tempted to try and gain market share in Europe. This suggests the need for lower prices, through a devaluation of CNY,  which would be disinflationary for the Eurozone as China accounts for 14%  of Eurozone imports.

This could actually support Eurozone consumer incomes, though if the US implemented trade restrictions, it is likely that the impact on Eurozone growth from any gain in Eurozone consumer incomes would be negated by reduced exports and or lower confidence. If global trade volumes contracted, then this would clearly have an impact on the Eurozone, especially on large exporter nations such as  Germany.

FOMC

Traders now await the US FOMC decision tonight. Last time around the Fed noted that they were awaiting further information regarding the policies of the incoming administration. The vital part for the Fed will be Trump’s proposed fiscal expenditure which has yet to be confirmed. So for now, the Fed is likely to remain on hold again and note that while recent economic data continues to support their proposed rate path, uncertainty remains.

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