The Trade War Trap
- Arnav Lanke
- Jul 23
- 4 min read
Central banks are no longer just fighting inflation – they’re also fighting political risk.
In today’s globalised economy, conflict no longer requires armed confrontation to stir markets; policy disputes and trade wars can be just as, if not more, destabilising.
One of the most profound of these consequences is the rise in economic uncertainty: the inability to predict future outcomes confidently in a volatile macroeconomic landscape. It is this uncertainty that places central banks under immense pressure, not only from shifting macroeconomic indicators but also from the wider political environment, forcing responses with limited clarity.
The Context:
On 2nd April 2025, Donald Trump declared a ‘national emergency’ over the US trade deficit, introducing sweeping tariffs under Executive orders. Under this policy, a baseline 10% tariff was imposed on nearly all imports, with higher rates of up to 50% for countries with which the US has the largest trade deficit, most notably China. These tariffs were named ‘reciprocal tariffs’, justified to restore US manufacturing competitiveness. The announcement triggered a sharp equity market crash, a surge in bond yields, and retaliatory tariffs from major trading partners, prompting the administration to pause the measures for 90 days (excluding China).
Central banks, like the Federal Reserve (Fed), play an important role in maintaining stability in the economy, particularly in influencing the overall money supply and credit conditions via monetary policy. This is primarily conducted by the Federal Open Market Committee (FOMC), which sets the target range for the federal funds rate. One of its core mandates is to maintain inflation around 2%, as excessive inflation erodes purchasing power, increases inequality, and may lead to higher unemployment.
The Fed’s Dilemma:
Trump’s Tariffs have created a problem for the Fed: they are inherently inflationary. Tariffs are taxes placed on imports coming into the US economy. With significant tariff hikes and the minimum baseline 10% tariff, consumer prices and input costs increase. Regional Fed leaders such as Richmond’s Barkin explicitly warned that tariffs “will start pushing up inflation”.
Typically, raising the federal funds rate (currently at 4.25-4.5%) would disincentivise spending and investment in the economy, subsequently reducing aggregate demand, reducing inflationary pressures from the tariffs. But in this case, higher rates could worsen the situation: retaliatory tariffs from countries like China weaken U.S. export demand and business confidence, which depresses industrial output and GDP growth. The Fed, therefore, is caught between conflicting goals, a situation that underscores how politically driven trade policies can undermine monetary policy effectiveness.
How Markets Reacted:
Markets responded dramatically to the tariffs with a swift and unforgiving equity sell-off.
The S&P 500 shed over 20% from its February peak, wiping out $5.38 trillion in value almost overnight. Europe followed this: the Stoxx 600 fell to January lows, while Japan’s Nikkei 225 and TOPIX plunged 2.8% and 3.1%. Across the Atlantic, the FTSE 100, CAC 40, and DAX declined 1.6%, 3.3%, and 3.1% respectively.
These sharp correlations reflect the investor fears over weakened company earnings with disrupted supply chains and higher production costs, particularly in the technological and manufacturing industries.
In US fixed income markets, this uncertainty was mirrored. Yields on 30-year treasuries spiked to around 5% in April due to inflation fears and uncertainty, raising the risk of bond investments.
Investor sentiment has become increasingly sensitive to political developments. Mixed messaging from the White House has created volatility that complicates forecasting. For the Fed, this is a major challenge since clear forward guidance is difficult when policy uncertainty is out of control. Markets now look to the Fed not just for rate decisions, but for reassurance in the face of political shocks.
The Fed’s Cautious Path Forward:
Fed officials, including Powell, emphasise waiting to assess the full inflation impact from tariffs, distinguishing between a "one-off" price jump and more persistent inflation. Other officials highlight the economy's weakening sectors and lagging job growth as reasons to postpone aggressive tightening.
As a result, the Fed has opted for a cautious stance, holding rates in the 4.25–4.5% range and signalling fewer cuts than markets expected. Officials projecting one or two cuts this year, such as Kashkari and Schmid, continue to stress the importance of patience amidst uncertainty.
The increasing political interference in monetary policy has complicated the situation. With Trump urging for rate cuts, markets have grown increasingly reactive not to the Fed’s decisions, but to political statements pre-empting monetary policy decisions. This could potentially threaten the credibility of the Federal Reserve. Monetary policy is most effective when it is data-oriented and objectively implemented. However, in this environment where tariffs have been radically deployed, the effectiveness of monetary policy is being tested.
This scenario illustrates how politically driven shocks undermine monetary policy effectiveness. The Fed is caught between mitigating inflation and avoiding a sharper economic contraction, with both outcomes potentially compromising its dual objectives of price stability and maximum employment.
References
Confino, P. (2025). Trump wants lower interest rates to “counteract” the inflation from his own tariff policies. Fortune. https://fortune.com/article/why-does-trump-want-lower-interest-rates/
Economic Times. (n.d.). Inflation vs growth: The Federal Reserve’s policy dilemma – Fed’s current stance on interest rates. The Economic Times. https://economictimes.indiatimes.com/markets/stocks/news/inflation-vs-growth-the-federal-reserves-policy-dilemma/feds-current-stance-on-interest-rates/slideshow/120785139.cms
Race, M. (2025, June 29). US bond markets: Why everyone is watching them closely. BBC News. https://www.bbc.co.uk/news/articles/cvg838qq7zqo#:~:text=In%20short%2C%20the%20uncertainty%20over,to%20compensate%20for%20taking%20it
Trading Economics. (n.d.). United States inflation rate. https://tradingeconomics.com/united-states/inflation-cpi
Wikipedia contributors. (2025). Liberation Day tariffs. Wikipedia. https://en.wikipedia.org/wiki/Liberation_Day_tariffs
Amazing and interesting article