How to be a macroeconomic dove in Trump’s trade war

Greetings Free Lunch readers.

It has become ever harder to be a central banker, and US President Donald Trump has made it harder still by launching an all-out trade war on the world. The most common way of thinking about rising trade barriers is as a negative supply shock for the tariffing nation. Since a negative supply shock pushes output down and prices up, it is the worst thing for central banks to handle.

The standard prescription is to look through the jump in prices or perhaps raise interest rates to counter any second-round effects. The Bank of England’s Megan Greene discusses this in an op-ed for the FT. That is especially so if tariff increases also cause a positive demand shock, adding inflationary pressure, which would depend on how the tariff revenue is spent and whether domestic businesses invest to take advantage of newly captive demand.

I think monetary policy doves are put in a particularly awkward spot by Trump’s actions. (I am focusing on the US here, as the tariffing nation, since in other countries the redirection of trade flows may reduce price pressures and straightforwardly support looser monetary policy.) Not only does standard analysis mean tariffs tilt the balance towards tightening, but Trump’s loud calls for lower rates should make independent-minded central bankers wary of agreeing, just to avoid giving anyone the idea they can be politically influenced.

Still, I think it is possible to be a dove with integrity. Below, I set out three arguments for how. Do you agree? Let me know at freelunch@ft.com.

The first argument is eccentric but unoriginal. The “eccentric” bit — out of the mainstream, that is — is to argue that current monetary policy is already quite restrictive (too much so) on the US economy. A version of this is how Trump’s latest Federal Reserve appointee, Stephen Miran, has justified his calls for significant rate cuts. My colleagues Robert Armstrong and Chris Giles have both had a go at analysing his arguments, which, to his credit, Miran has set out quite transparently.

In a nutshell, they claim that recent changes in the economy and Trump’s economic policy have lowered the “neutral” rate of interest, so the Fed policy rate should follow it down to avoid restricting growth. Tl;dr version: my colleagues find his reasoning unpersuasively selective. My hunch is that they are right. If anything, I would guess the neutral rate is being nudged upwards by the economic consequences of Trump, such as a more inefficient supply side due to tariffs and attacks on the dollar’s attractiveness, combined with an artificial intelligence investment boom and continued large fiscal deficits.

But Miran could be right for the wrong reasons, if one thinks monetary policy had long been too tight and the neutral setting significantly lower. Hence the “unoriginal” bit — you could think rates are too high now if you were already arguing they were too tight for some time. Regular Free Lunch readers will know of my scepticism of the 2022-23 interest rate rises in the face of what I still judge as mostly supply-side and sectoral composition shocks.

This view requires one to think that additional demand could be met without significant inflationary pressures, and that the 2021-22 inflation would have come down without the monetary policy tightening. Reasons to believe this include the timing of when inflation started turning (ahead of the policy tightening), the fact that working-age employment rates have stayed below historic highs, and the obvious absence of unemployment as the mechanism through which higher rates are supposed to have worked.

There are plenty of arguments against this view, to be sure. The point here is not to ask that you adopt it. It’s just to describe one type of analysis that the macroeconomic doves among us have already advanced for some time, which would support monetary loosening in the US today even if the Trump tariffs might weaken the case by adding to the arguments for tightening or staying put.

But there are also arguments that take the tariff shock as a separate argument for loosening. That should surprise you (it surprises me), given the conventional take on tariffs as a negative supply shock. So here is a recent paper likely to raise some eyebrows. This spring — nicely timed for Trump’s massive tariff announcements — Javier Bianchi and Louphou Coulibaly, both associated with the Federal Reserve Bank of Minneapolis, published a model where the right central bank reaction to a tariff jump is to stimulate the economy, and let both inflation and production rise above normal rates.

The intuition is as follows. A tariff on foreign goods makes these goods look more expensive to consumers than they really are for the economy. Consumers collectively also consume too little of imports because each individual consumer doesn’t take into account that the tariff they pay benefits others (by paying for spending or tax cuts). These externalities mean that with tariffs, imports are inefficiently low — so the best monetary policy is one that counteracts this by loosening conditions and allowing inflation to rise by more than just the full tariff costs being passed on to prices.

It’s a curious result, best seen as an example of the general theory of the second best: once one thing is distorted in an economy, you don’t get the best achievable result by keeping everything else undistorted but by distorting other things to compensate.

The curiosities don’t end there. The model predicts that the optimal monetary policy makes employment in domestic production go up, and leads the external balance to improve. That’s because with more production and, therefore, income, people not only buy more imports but also save more — and on the level of the national economy, the increased savings have to be invested abroad. The prediction is, in short, that Trump achieves a lot of what he is aiming for. Let’s be clear: intellectual rigour means this should not count against the research.

We should immediately note that in the model, all these outcomes do leave people overall worse off than they otherwise would have been, because they have to put in more work for worse consumption bundles than in a free-trade equilibrium. But general economic wellbeing may not be what Trump cares about if he can get more domestic manufacturing and a smaller trade deficit — even if it’s a result of the central bank trying to counteract his protectionism.

In sum, a benevolent central bank does what Trump wants it to do (cut rates) in order to try to frustrate another thing he tries to do (protectionism) and ends up advancing many of his goals in the process while sparing consumers some of the hardship Trumponomics imposes. It’s a strange model, for sure, whose curious outputs depend on curious ingredients. But do read the paper.

There is a third argument for thinking the Trump shock justifies looser monetary policy. Like the previous one, it has to do with the structural changes induced by the tariff increases. But rather than asking what monetary policy would reverse some of the damage, it asks what monetary policy could help the required structural transformation along. And the key observation here is that a significant recasting of cross-border supply chains and of the economy’s productive structure will require physical capital investments and changes in relative prices, including those of different types of labour.

Now physical capital investments are more likely to be made, or to be made faster and at larger scale, when the cost of borrowing is lower. And relative price changes are a lot easier to achieve when all prices are going up at pace than when some prices — let alone wages — have to outright fall. So on both counts, lower interest rates and tolerance for higher inflation over a period of time are conducive to achieving a structural transformation if one is needed. And if overly conservative monetary policy makes for a delayed or incomplete structural transformation, income could be permanently lost relative to what is achievable.

There are heresies involved in all three arguments: they all imply that monetary policy can have long-term effects on real productive capacity, that is to say, on the supply side of the economy. No doubt many readers have strong views about why this is wrong — we want to hear them! Send misgivings — and agreements too — to freelunch@ft.com. In the meantime, never forget that some heresies are true.

Other readables

● Europe does not have the private or public sector recklessness that fuels tech investment in the US and China. So it needs to find its own European way to boost risk capital, I argue in my FT column this week.

● With the right policies, poor regions can catch up fast.

● Has social media use peaked? John Burn-Murdoch thinks it might have.

● Unhedged has a good overview of the “is US growth only about AI” debate.

● Matthew Klein at The Overshoot is excellent on why balance of payments crises matter and what it means for the US loan to Argentina.

● How much do markets really care about Europe’s temptations to confiscate Russian foreign exchange reserves?

● From bendy solar panels to nuclear fusion, the FT’s climate tech explainers have you covered.