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The US Economy

Fed Independence

• The biggest source of risk to the US economy is the loss of Federal Reserve independence. Trump said the benchmark federal funds rate should be reduced from its current 4.25-4.5 per cent range to around 1 per cent. What is less clear is whether this represents the firm policy intention of the President, or whether this is just a political distraction, or a way to blame someone else for any pain arising from the new tariffs. If money markets come to the view that the Federal Reserve was not taking sufficient action to bring inflation to target, bond yields would rise in line with long-run inflation expectations (regardless of the Federal Reserve policy rate), and the cost of sustaining the US national debt could increase significantly.

US Trade Wars

Analysis

The US will end up with higher tariffs

1. Trump is ideologically committed to tariffs, and short of a disaster in implementation, the US is likely to end up with an increased tariff regime at the end of a protracted and probably chaotic negotiation process.
2. Trump’s baseline 10% tariffs on every nation are likely to stay in some form as they are a new revenue source for the government. Given the Republicans traditional hatred of new taxes, this might be Trump’s only way to (at least partially) address US fiscal problems and/or offset the costs of continued tax cuts.
3. The April-2-announced-then-paused additional tariffs on creditor nations (the so-called reciprocal tariffs) are primarily a negotiating tactic in Trump’s inimitable idiosyncratic style. He will ultimately reduce them or remove them where the targeted countries offer some significant concession to the US for their trade imbalance. In the short-run, this is a shakedown. In the longer-run, it is unclear whether Trump will continue to sustain sufficient market and public support for these add-on tariffs. 
4. Some form of super-tariff on China is likely to remain (see below).

The US tariff negotiation process could become messy

5. Trump will muddle though the tariff negotiation process: he will add new tariffs, pause tariffs, reduce tariffs, increase tariffs, remove tariffs, and back track as he negotiates with the rest of the world. If he fails to move forward with one country, he will shift focus to another country. He sees unpredictability as a negotiation strength. He does not play by the conventional bureaucratic rule book. 
6. Negotiating credibility requires him to be rougher, tougher and meaner than he was in 2018-2020 tariff cycle. Because Trump needs to be tougher, he is happy to take some market pain to pursue his negotiating strategy. His strategy will continue to provide short-term shocks to bond and equity markets in the US (and globally). 
7. But this is a high-wire act. Trump would not want to crash markets, see a flight of capital away from the US, nor bring on a full-blown recession. Hence, I expect markets to be tested and then eased back on multiple times. Market volatility will be high during the negotiations.
8. It is also a lot of work. Trump is trying to negotiate with perhaps up to 100-plus countries at once. This is a Herculean task for the US, that benefits the nations in the rest of the world. each of whom only need to negotiate one agreement with the US.
9. China, Mexico and Canada have been subject to this strategy once before in the 2018-2020 tariff cycle. All nations would have learnt that capitulating to Trump does not buy long-term reprieve or certainty from Trump’s US. Consequently, Trump is likely to find this round of negotiations much more challenging than the 2018-2020 round. He runs the risk of being seen as a one-trick-pony. No-one likes to be repeatedly extorted with the same strategy – it will be a case of once bitten, twice shy.  If Trump is not careful, rougher, tougher and meaner can quickly look like an over-exaggerated pantomime when it is ignored.

China is a particular focus of US concern

10. China is a growing threat to US hegemony and dominance. China has grown quickly over the past 35 years. Its global trade has exceeded the US every year since 2012. Trump’s tariffs appear to have the added objective of constraining China’s trade and geo-strategic ambitions. Trump undoubtedly wants to tighten the screws on what he sees as China’s poor trade practices. Consequently, China is likely to have higher US tariffs compared with other nations.
11. China is not without options in this negotiation:

• First the US negotiating hand is weakened by its large fiscal debt and deficit. If Trump moves too far or too fast, it could trigger a fast devaluation of the US dollar, a flight of capital from the US, an increase in the US inflation rate, and/or a increase in the US Treasury bond yield rate. 
• Second, the US negotiating hand is weakened by any public reaction to higher prices for Chinese imports or (if nothing is resolved quickly) empty supermarket shelves. 
• Finally, China can more easily purchase from the rest of the world what it currently imports from the US; than the US can import from the rest of the world what it imports from China.

12. It is possible that as part of its negotiations with other nations, the US will ask its interlocutors to impose similar tariffs on China. You can expect China to retaliate against any nation that participates in a US-led tariff blockade of China. If the US and China get into these positions, Australia could find itself with some difficult choices.
13. China would not want to lose face by being humiliated into providing more trade concessions.

Final observations

14. While Trump will continue to use the rhetoric of repatriating industry to the US, his approach is unlikely to achieve this goal (it just doesn’t offer the policy certainty over the 20+ year time horizon business needs to bring manufacturing back to the US). I suspect Trump knows this. Nonetheless, the rhetoric is useful red meat for his supporters.
15. I do not for one second think Trump is playing 4D-chess or executing a sophisticated and finely calibrated optimal tariff theory approach. It is not who he is. This is a bare-knuckled playground bully brawl.