I suspect that Thursday’s trade war talk will only intensify the focus on rising interest rates through the Spring. The President’s steel and aluminum tariff announcement follows a familiar pattern: announce an aggressive policy that makes for good headlines with the voter base, then let political staff water it down as they hammer out the fine print. Recognizing that the steel tariffs may stand as-is but are not the end-game, the President’s trade stance has a reasonable chance of following this pattern once again, ultimately proving non-destructive for the economy.
However, the tariffs will cause a clear increase in the price of steel for US companies. As a basic feedstock of so many industries, this will add another inflationary impulse in an economy that is already running hot. This fact will not be lost on the Fed: the odds of a fourth rate hike this year have increased, meaning short-term rates may end the year above 2%.
Interestingly, this creates a uniquely American issue: the US economy is further along in its economic cycle than other economies, and steel prices will be inflationary within the US while disinflationary elsewhere. As a result, the gap between interest rates in the US and those in the rest of the world is likely to continuing to widen through 2018. For example, the ECB’s rate is still likely to be negative at the end of this year. This combination of high economic growth and high relative interest rates in the US is familiar: it was the cause of the US dollar’s enormous, 70% appreciation under Reagan during the first half of the 1980’s (chart attached for context – the reversal in 1985 came only after coordinated central bank intervention via the Plaza Accord).