Why Trump’s tariff plans could lead to higher interest rates

By Bryan Mena, CNN

Washington (CNN) — President-elect Donald Trump’s promise to impose stiff tariffs against America’s three biggest trading partners is widely expected to push prices higher, which would set the stage for the Federal Reserve to stop cutting interest rates and possibly raise them instead.

Fed Chair Jerome Powell said in a recent speech in Dallas that it is still too early to consider how Trump’s tariff plans would affect the US economy. Campaign rhetoric is one thing, but enacted policy is another. Trump, however, says he won’t waste any time, threatening last week to slap 25% tariffs on Mexico and Canada and an additional 10% duty on Chinese goods on the first day of his second term on January 20.

Trump’s tariffs would almost certainly push up prices for imported goods like avocados, cars and tequila. That would affect about $1.5 trillion of goods that flow throughout North America, according to an estimate from the International Monetary Fund.

Wall Street has already shown some concern over the possibility of inflation reigniting under a second Trump term, with bond yields ratcheting higher leading up to Election Day and in the weeks after.

On the bright side, since persistently high inflation, induced by hefty tariffs, would prevent the Fed from lowering borrowing costs, cash-like and bond investments could keep some of their luster for a little longer, too.

Retaliatory tariffs and consumer perceptions

Fed officials will eventually develop economic models of how the US economy could perform under different tariff scenarios. Two potential developments they’ll consider will be whether retaliatory tariffs emerge from Trump’s plans, if enacted, and if Americans believe inflation will pick up.

That’s precisely what the Fed did in 2018 when the first Trump administration went on a tariff spree, slapping duties on foreign goods ranging from solar panels to washing machines.

In one scenario, assuming retaliation against a 15% universal tariff, the Fed deemed it best to raise rates if Americans also expected inflation to pick up. That was the formula for the Fed to raise rates: a trade war and spooked consumers, according to a declassified 2018 Fed document detailing policy alternatives known as the “tealbook.”

Mexican President Claudia Sheinbaum has already suggested retaliatory tariffs in response to Trump’s threat.

The Fed pays close attention to Americans’ perception of inflation, but that doesn’t present a problem at the moment: Americans’ expectations for inflation in the year ahead declined markedly in November, according to The Conference Board’s latest consumer survey, falling to the lowest level since March 2020.

Despite the better outlook on price increases, “consumers overwhelmingly selected higher prices as their top concern and lower prices as their top wish for the new year,” the Conference Board added.

“Today’s economic environment differs meaningfully from 2018, (and) while the inflation heatwave is mostly past us, its embers are still alive,” said Stephanie Aliaga, global market strategist at JPMorgan Asset Management. “Consumer expectations (for inflation) have hovered around 3% since May 2021, half a percentage-point higher than their range in 2018 and 2019.”

Some relief ahead still?

For now, the Fed is poised to carry on with rate cuts based on current conditions. Unemployment remains low, consumers are still spending and inflation has slowed and is expected to slow more, despite hitting a bump recently.

Though there might not be a whole lot of relief from borrowing costs in store.

“The economy is not sending any signals that we need to be in a hurry to lower rates,” Powell said at his Dallas speech in mid-November.

And even though the Fed has begun to cut rates, mortgage rates, which track the yield on the 10-year US Treasury note, have risen since the Fed’s first rate cut in September.

Still, Fed officials believe that borrowing costs are still too high, according to recent speeches, which means they’ll deliver a few more rate cuts to ease the grip on the economy.

“With the economic landscape underpinned by a resilient labor market, and solid consumer spending, the Fed remains concerned about lower wage earners still struggling with higher interest rates,” Quincy Krosby, chief global strategist at LPL Financial, wrote in a note Wednesday.

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