Macro Signposts | 8 January 2025
This week, I asked economist Graeme Westwood to coauthor Macro Signposts to help analyze how Federal Reserve policy decisions and related currency moves are crucial to the impact and effectiveness of tariffs.
Tariffs, the Dollar, and the Fed: Crucial Decisions in 2025
By Tiffany Wilding and Graeme Westwood
Since November's election, measures of trade policy uncertainty have skyrocketed. Forecasting the scale, scope, and impact of the second Trump administration's trade policy ambitions is difficult because rebalancing global trade requires changes to not only U.S. but also foreign economic policies that in turn shape global savings and investment behavior.
The current trade policies have produced clear winners and losers, and efforts to bring these more into balance would have unequal impacts on different sectors of the U.S. and global economies. As we argued recently, U.S. capital holders have likely benefited from the current system, hence President-elect Trump's tolerance for losses or shakiness in U.S. equity markets may be key to how quickly and forcefully he enacts trade policies (see our 17 December 2024 Macro Signposts: "Will We See Bold Policy Choices in the U.S.?").
Another key question is how central banks, and specifically the Federal Reserve, will respond. Fed officials will have to weigh the potentially offsetting risks that trade policies could have for the Fed's dual mandate: price stability and maximum employment. Fed policy affects the strength of the U.S. dollar, and this currency adjustment could then determine who bears much of the near-term costs of tariffs, and how great those costs are.
No matter what the Fed does, it may be dragged into the politics despite its ambition to maintain independence. Indeed, through rates, currency, and trade linkages, the Fed may have more influence than it desires over the administration's ability to revitalize the U.S. manufacturing sector.
The role of exchange rate offsets
The central bank's policy could largely determine who ultimately pays the tariff since its policy choices tend to affect the exchange rate. To see how this could work, consider two scenarios, one with perfect currency offset of a universal basic tariff increase, and one without:
Each of these scenarios has winners and losers, and whether the currency adjustment fully or partially offsets the tariff will be influenced in part by the central bank's actions. Higher short-term interest rates, all else equal, should contribute to the currency adjustment, while more accommodative policy could limit it. Building off recent research published by the World Bank,1 we examined 16 advanced economies from 1960 to 2019 and found that the real exchange rate increased by 60 basis points (bps) in the first year following a 1 percentage point increase in the tariff rate. Interestingly, it appreciates by 1 percentage point after two years, after which it stabilizes, reflecting a longer-term offset to the policy action.
Monetary policy and the Fed's dual mandate
What is the Fed likely to do? Under a classic Taylor rule (after economist John Taylor, who introduced it in 1993), the central bank sets monetary policy to align with the current cyclical conditions of an economy. If an economy is operating above capacity and inflation is above target, the central bank's rate should be set above neutral to rebalance conditions, or vice versa in a below-capacity environment. With tariffs, because the near-term impacts tend to be higher inflation but lower real economic activity, the central bank must weigh the relative merits of more accommodative policy to support growth and employment against more restrictive policy to restrain inflation. In addition, research that has found that central bank policy can influence supply-side growth fundamentals, including labor supply expansion and productivity, with potentially meaningful implications for the long-run trajectory of the economy.
Although a tariff mechanically will raise inflation following its implementation, the Fed could see this as a one-time price level adjustment rather than generalized inflationary pressure. If the central bank is not concerned about this price level adjustment embedding itself into inflation expectations, then the optimal policy may be to look through the shock, as consumers tend to adjust their behavior in response to the changing relative prices of goods and services.
How have central banks reacted to tariffs historically? Using the dataset cited above, we found that central banks on average raised the policy rate by 13 bps for every 1 percentage point increase in the effective tariff rate. However, this response was not symmetric across economic environments. Central banks were more restrictive – with short-term interest rates rising 40 bps – in high inflation environments in which 3-year average inflation exceeded 4%. In low inflation environments, short-term interest rates were unchanged. This suggests that the response of monetary policy depends on the prevailing state of the economy.
If past is prologue, the recent pandemic-related inflation episode could tilt the scales toward a greater Fed focus on inflationary risks. Although the Fed may not be hiking, it could very well cut by less than it was previously expecting. Staying on hold, versus the cuts currently priced into markets, could very well support a fuller exchange rate adjustment (a stronger dollar).
What recent experience suggests
While we await clarification on Trump tariffs, markets have already begun to digest the implications. The U.S. dollar index has risen over 4% since the end of October, although it briefly fell 0.8% on Monday (6 January) after a Washington Post article2 suggested that the Trump administration's tariff plans are more limited. This reaction suggests we may see some offset to the price impact of any tariff, while the higher elasticity of U.S. export demand implies that the exchange rate could also weigh on growth.
This tension between growth and inflation could make the Fed's job difficult, especially as the recent inflation surge keeps inflation expectations more top of mind than when new tariffs were introduced in the first Trump administration in 2018. Remaining on hold for longer – or even raising the policy rate (though unlikely) – may keep inflation expectations in check, but at the cost of curtailing U.S. exports. On the other hand, lowering the policy rate likely would support exports but force U.S. households to bear the costs of tariffs more heavily
President-elect Trump has expressed a desire to use tariffs to revitalize American manufacturing by incentivizing domestic investment and reshoring. In the end, the Fed may determine whether he succeeds.
1 Davide Furceri, Swarnali A. Hannan, Jonathan D. Ostry, Andrew K. Rose, "The Macroeconomy After Tariffs," The World Bank Economic Review, Volume 36, Issue 2, May 2022, pages 361–381
2 "Trump aides ready 'universal' tariff plans – with one key change," The Washington Post, 6 January 2025
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