How trade wars, monetary policy and the business cycle are connected

Recent news has been dominated by the trade war with China and uncertainty about the future path of Federal Reserve policy. These events are related, but not in the way you might assume. With apprehension about a recession growing, let’s look at the relationship.

Broadly speaking, two types of shocks can hit an economy. “Real” shocks directly affect economic activity by interfering with the efficient allocation of resources. The current trade war, which places barriers between willing buyers and sellers, is a good example. “Real” factors like labor, capital and technology determine long-run economic growth and explain why some countries are rich and others are poor. Nonetheless, real factors play only an indirect role in creating recessions.

Conversely, “nominal” factors like monetary policy are not important for long-run growth, but nominal shocks are very important in the short-run business cycle. That’s because everything from labor contracts to mortgages are usually specified in nominal (dollar) terms, and hence are impacted when monetary shocks influence nominal spending.

Nominal shocks occur when unstable monetary policy leads to a rise or fall in nominal GDP, which measures the total dollar spending on all goods in the economy. In the long run, wages and prices adjust and money is “neutral” — only real shocks matter.  But when nominal GDP falls suddenly, as it did in 2008-09, there is less total income available to pay workers’ nominal wage and debt contracts. Unemployment rises and debt defaults increase.

It would be nice if we could cleanly separate real and nominal shocks. But unfortunately they get entangled because of the way the Fed conducts monetary policy. If a negative real shock such as a trade war makes businesses more reluctant to invest, the “equilibrium interest rate” – roughly that which would keep the economy stable – declines, as there is less demand for credit and thus the price of credit should fall.

Ideally, actual market interest rates would move in tandem with the equilibrium rate. But in the real world, the Fed is often too slow in changing its short-term interest rate target, and this can result in market rates moving above or below the equilibrium interest rate. When this interest rate is set above the equilibrium rate, as it’s been in recent months, monetary policy becomes effectively tighter, with excessively high rates slowing spending and economic growth.

Even the Fed’s recent quarter-point rate cut was not enough. Rapidly plunging longer-term bond yields provide a hint that the equilibrium interest rate is falling faster than the Fed’s rate. This is one reason why declining bond yields often occur on days when there is a stock market crash. Both markets are responding to the same reality — bearish expectations about the economy 

This also helps to explain the paradox that trade wars can be deflationary. Economists would normally expect tariffs to raise inflation, as they are mostly passed on to consumers in the form of higher prices. But when trade wars lead to a sharply lower equilibrium interest rate and the Fed fails to respond quickly and in kind, this slows the economy.

We’ve seen the pattern before. In 2006 and 2007, a severe housing slump had only a modest impact on the economy, as housing construction is generally less than 6 percent of GDP. But when the Fed failed to cut rates as quickly as the equilibrium rate was falling in 2008, nominal GDP began falling. Unemployment soared much higher and debt defaults increased as the recession spread to industries unrelated to housing.

This also explains why recessions are so hard to predict. Trade with China is not a big enough share of the economy to directly cause a recession. The impact of a “real shock” depends on how adeptly the Fed responds to the changing equilibrium interest rate. It’s too soon to know if the Fed will cut rates quickly enough to prevent nominal GDP growth from falling sharply.

If the Fed cuts rates as fast as the equilibrium rate declines, then the damage from tariffs will be confined to a few sectors. If the Fed reacts too slowly in an increasingly bearish investment environment, nominal GDP growth will decline and the effect of tariffs will spread far beyond the directly impacted industries.

Think of the Fed as a ship captain, trying to move the steering wheel into exactly the position that offsets the effects of wind and waves. The problem is that it’s hard to be certain as to when monetary policy is off course, except in retrospect. Current market indicators suggest that the Fed has been a little too slow in cutting rates during 2019, but it will be some time before we know for sure.

Scott Sumner is an emeritus professor of economics at Bentley University and the Ralph G. Hawtrey chair of monetary policy at the Mercatus Center at George Mason University.