Media Release September 3, 2019

The real trade war risk: Zero rates and deeper recessions

The latest escalation in the trade spat between the U.S. and China has once again roiled global markets. Lower equities and oil prices and flatter (and inverted) yield curves all point to one thing: rising risks of a downturn in the U.S. and global economies in the quarters ahead. While these concerns may be well-founded, the more consequential cost of this escalation has thus far gone unsaid. By forcing the Fed to cut interest rates sharply now to respond to a trade-induced sputtering in growth momentum, the U.S. economy may be stuck with near-zero rates in the future, leading to more frequent and protracted recessions with significant economic costs.

Recent economic history has taught us that once an economy adopts a (near-)zero interest rate policy, returning to a more normal environment with significantly positive interest rates should not be taken for granted. Japan’s decades-long struggle with zero and negative interest rates is the most obvious example, but a number of major economies have been unable to escape the magnetic pull of low interest rates even a decade removed from the global financial crisis.

In sharp contrast, the U.S. has unwound much of its post-crisis monetary accommodation. Aided by a massive infusion of fiscal stimulus through tax cuts and government spending increases, the Fed lifted its policy rate from near-zero levels in 2015 to just below 2.5 percent by the end of 2018. The policy buffer gained by this normalisation, if preserved, would be critical in helping the Fed to respond more effectively to unforeseen shocks that could trigger future downturns.

However, by forcing dramatic rate cuts now to counteract the economic fallout of the escalating trade war, the Fed looks set to forfeit this hard earned policy space. Since the announcement of additional tariffs on August 1, markets have priced an additional 40 basis points of rate cuts through the end of next year. To put this into perspective, the near one percent fed funds rate implied by this pricing is less than half of the level that prevailed just about a month ago prior to the July Federal Open Market Committee meeting. More strikingly, it is less than one-fifth of the level the Fed had at its disposal to respond to the global financial crisis and even further below the six percentage points slashing of the fed funds rate that has accompanied post-war recessions on average.

Adopting lower interest rates now would not be as concerning if the Fed had alternative tools that were as effective as the fed funds rate in easing financial conditions. They do not. Numerous studies, including those headlining the Fed’s marquee research conference in Chicago in June, have concluded that unconventional policies like asset purchases are imperfect substitutes for traditional interest rate policy. That is, the Fed cannot perfectly replace the easing capabilities of rate cuts with other monetary policy tools.

The impact of losing this monetary ammunition cannot be overstated, as recessions can have long-lasting debilitating effects on the economy. Households that lose their jobs during a downturn experience a loss of skills, experience and labour market attachment that cannot be easily recovered. Together, these outcomes negatively impact lifetime income and impair quality of life. This damage to the labour force may have adverse effects on long-term economic growth prospects in the U.S., a fact that is particularly worrying for an economy already dealing with the effects of an ageing population and subdued productivity.

Amongst the population, more frequent and severe recessions that could come with restrained monetary policy will also disproportionately damage the very households that the trade war is purportedly intended to benefit. Unemployment rates tend to rise more sharply for low- and middle-income households in recessions. Income loss is, similarly, more severe for these groups. This is also true across different occupations, as recessions over the past three decades have coincided with a permanent loss of employment in those sectors most susceptible to automation and outsourcing.

As with any policy decision, both the pluses and minuses of the current trade negotiations must be considered. To be sure, there may well be long-term benefits to the U.S. economy from a successful conclusion to these talks that includes, among other things, protection of intellectual property, cessation of coercive technology transfers, and more open access to a large and growing consumer market for U.S. goods and services. But these gains must be measured against the full cost of these actions. It is not enough to worry just about the near-term damage to markets or the economy; we must also be concerned that monetary policy will be more permanently constrained by zero interest rates, all but ensuring more frequent and severe recessions.

Author: Matthew Luzzetti, Chief US Economist, Deutsche Bank Research

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