Tariff Risks are Minimally Responsive to Rates a.k.a. Why the Fed Can’t Save the Economy in the Short-run
- The Fed has substantial policy space to ease in the event inflation allows it to (which means a sharply worse growth outlook starting to be realized). The absence of widescale balance sheet issues also mean that that easing should be fairly effective ceteris paribus, unlike during the aftermath of the GFC when balance sheet repair attenuated the impact of rate cuts.
- But if the China tariffs stay in place, the Fed could not solve the impacts, even if inflation eventually allows it to try.
- The nature of the shocks is initially too concentrated and fundamental to be offset by changing the risk-free rate and the cost of capital. The Fed may be able to partially counteract them over time but with substantial and avoidable dislocations that will persist.
- COGS, the obtainability of goods to sell period, and the availability of working capital under stress to try and wait for enough damage to emerge that the tariffs are reduced, matter far more than the fed funds rate and are all downstream of tariff policy choices.
With the drumbeat of concerns around the coming stresses, to put it mildly, in any part of the economy dependent on Chinese imports its worth making the most essential point: monetary policy will do approximately nothing for those firms most impacted.
If the China tariffs stay in place, the Fed could not solve the impacts, even if inflation allowed it to try. It may be able to partially offset them over time but with substantial and avoidable dislocations.
The tariff shock is a policy choice, but even if unwound today some of the uncertainty effects and direct impacts will linger. The longer it drags on though, the more endogenous the supply- and demand-side effects will become, even if they are unusual in cause.
As we go through the next few months, it is important to remember that demand pull-forwards by consumers and a rush to beat tariffs for firms have flattered much of the data for the goods economy in recent months, likely including April. This artificial bounce will lead to a drag later on over the next 2-4 months. Deciphering between that mechanical hangover and a real deterioration in underlying growth will be a challenge. I’ll be most focused on the layoffs-related data, any signs of investment getting pulled, and how housing actively is responding while we’re most in the fog of war in the spring and early summer. Color from highly impacted industries will help as well but that is so tariff centric while it will aid in scaling the initial shock’s impact, the broader macro read may not be immediately obvious in helping assess which of the many plausible paths we are on (especially as tariff news keeps happening).
Bank earnings season consistently noted that the economy was in good shape in Q1 overall. However, they have seen some continued signs of stress in lower-income consumers (an ongoing theme) and that they expect economic weakness to be concentrated in small-and-medium sized enterprises going forward (see more here). A number of firms and leaders in the shipping industry and related sectors have recently highlighted just how bad they expect the coming shock to be if it stays in place. Indicative lines such as “I’m not sure what’s going to happen. But a lot of companies are definitely going under, that’s for sure [in the toy industry]” (listen here) and “small businesses are largely unable to move their manufacturing out of China. They are last in line when they try to go to a new country as those other countries can’t even keep up with the demand from mega corporations” (from shipping co Flexport’s CEO, here). Relative to larger firms small-to-medium sized enterprises lack the ability to shift across suppliers, effectively lobby for exclusions, and access capital markets directly.
The highly uneven nature of current tariffs allows for some firms to effectively ship production and costs around but for those with concentrated supply chains there may simply be no alternative on any economically reasonable time horizon.
If you have no goods to sell or trying to preserve margin takes your relative prices so far out of line that you lose any competitive advantage on a long-enough timeline, you’ll go under on some horizon. Once closed, the doors will not reopen quickly, if ever. That has nothing to do with the cost of capital for your firm, rather it is access to product at reasonable selling prices and, realistically, working capital (who will make new loans to the most impacted firms whose odds of bankruptcy face a clear jump risk?). SMEs will have little ability to shift sourcing in the short- or perhaps longer-term, and even if longer-term alternatives are available access to them requires surviving the short-term. West coast truckers and small goods retailers are the prime examples.
The Fed may have the ability to ease eventually but that will boost housing and durable goods (if longer-term market rates go along with cuts and affordability concerns are not further accentuated by tariffs on steel + lumber + immigration shifts), not save those hit most directly by tariffs in the near-term.
A highly concentrated layoff cycle where consumers rotate lower real spending into other sectors may see some partial attenuation but low and likely heading lower hiring rates in the near-term will see limited ability of laid off workers to avoid at least some period of unemployment. A slower breakeven pace of NFP growth due to much slower immigration “helps” avoid some slack, but the labor market will still trend easier over time. It is likely that services are a relative winner in this world but, with the aggregate real income hit and layoff risks, it seems highly unlikely that they win relative to a no tariff counterfactual.
An additional issue here is that with notable easing is already priced into market rates, taking the fed funds rate to a trough of roughly 3% in late 2026, we may not over-deliver on pricing. The broader policy environment may stoke fears of a hawkish pivot after easing (if we do not see substantial labor market slack emerge) and inject further term premia into the long end, offsetting or more any boost from lower policy rates for the vast majority of borrowers.
