The Fed can’t fight a trade war

Central banks can stimulate demand, not supply

John H. Cochrane

The Grumpy Economist

John H. Cochrane | Nov 12, 2019

Sections Economics Public Policy

Collections Monetary Policy

Should central banks offset trade wars? Given that the United States has started a trade war, and given that the Federal Reserve, the European Central Bank, and other central banks are easing monetary policy to offset trade headwinds, it’s a question that bears consideration. 

Central banks, including the Fed and the ECB, seem to take for granted that any reduction in economic activity, including a trade-war-induced slowdown, demands offsetting monetary stimulus. But stimulus can only provide aggregate demand. What if the problem is aggregate supply? What if an economy is humming along at full demand, and then someone throws a wrench in the works, be it a trade war, a bad tax code, or a regulatory onslaught, and that supply shock causes a slowdown? 

Conventional wisdom says that central banks should not offset reductions in aggregate supply. The first job of a central bank should be to distinguish demand shocks from supply shocks, so it can react to the former but not to the latter. This standard wisdom emanates from the 1970s, when central banks kept rates low to offset the effects of oil price shocks—supply shocks—and ended up producing worse recessions and inflation.

When I express this once-standard view at central banks these days, people stare at me with blank expressions. Distinguish supply from demand shocks? Why would we do that? Central bankers seem to assume that all fluctuations in output, employment, and prices come from demand. Yet this 1960s-era Keynesian view should have died a long time ago. Surely some shocks come from supply, not demand? 

The Fed—like the ECB—is pursuing looser policy, and is pretty clearly fighting trade-war headwinds. On August 1, the Fed lowered its target for the federal funds rate by 25 basis points, the first such decline since 2008. It lowered the target by a further 25 basis points on September 19, “in light of the implications of global developments for the economic outlook,” as well as flagging inflation.

Parrying the effects of a trade war is not in the Fed’s mandate, nor—for the most part—is it within its power.

Now, according to the conventional view, central banks should not offset supply shocks because that would cause inflation, rather than stimulate output. But right now we have inflation once again drifting slightly lower. So perhaps the trade war is a demand shock after all? 

Perhaps, but it’s hard to see how. Certainly the immediate impacts are on supply. Global supply chains are disrupted: people have to find new suppliers, who inevitably have worse products at higher prices than before. That’s all supply—reductions in the economy’s productive capacity. 

Perhaps the policy uncertainty about the trade war is causing a decline in demand. Why build a factory if any day now another tweet could render it unprofitable? 

Still, even if we are facing that kind of demand shock, it’s not obvious the Fed should try to counteract it with stimulus. Yes, the specter of a trade war—or the kind of serious political and trade turmoil that may follow the recent unrest in Hong Kong—is a “confidence” shock. But the uncertainty is genuine. A rise in risk premia in an uncertain environment is genuine. People should hold off building factories that depend on a Chinese supply chain until we know the full extent of the trade war. Why should the Fed try to goose such unwise investments by artificially lowering the short-term rate? Should the Fed become (ever more) psychologist in chief, decreeing that such fears are irrational? Does the Fed really have any better idea how likely or damaging a trade war will be than people whose money is on the line? 

Now, it is perfectly natural for interest rates to fall in response to trade concerns. Any adverse supply or productivity shock also lowers the expected real return on investment. As long as the Fed is in the business of guessing the right interest rate, it should follow the downward movement in the natural rate of interest that a trade war or other supply shock produces. But how much does a trade war, or fears of a war, lower the natural rate? This still does not justify the same interest rate response to all sources of output decline—supply or demand—or (in our case) fear of output decline that has not happened yet.

Another possibility is that the Fed is now watching the exchange rate, as most other central banks do. Not much in monetary policy seems to work as conventional wisdom expects, but raising interest rates does raise the relative value of the currency. The trade war has raised the value of the dollar, a trend the US clearly wants to keep in check—but even here, just why is an open question. Sure, exporters like a weak dollar. And importers and US travelers like a strong dollar. Why does a trade-war-induced slowdown change this relative calculus?

Parrying the effects of a trade war is not in the Fed’s mandate, nor—for the most part—is it within its power. The Fed can prop up asset prices and help encourage consumers to buy more stuff. But it can’t fill the void when there is suddenly less stuff to buy. Politicians create trade wars. If the US wants to minimize the economic damage from its current scuffle, it should look to its politicians, not its central bank, for solutions. And central banks might consider not so easily papering over the economic consequences of bad policies invented elsewhere.

John H. Cochrane is a senior fellow at the Hoover Institution at Stanford University and distinguished senior fellow at Chicago Booth. This essay is adapted from a post on his blog, The Grumpy Economist.