Trump's Trade War: The New Inflation Threat

The Federal Reserve has been on a rollercoaster ride since the pandemic, trying to tame inflation that surged to levels not seen in decades. After years of aggressive rate hikes and balance sheet reductions, the Fed finally seemed to be making progress. But just as the economy was starting to cool down, along came President-elect Donald Trump with his proposed tariffs and immigration policies, threatening to reignite inflationary pressures.

The Fed's response to the post-pandemic inflation surge was swift and decisive. Starting in March 2022, the Fed began raising interest rates at a pace not seen in decades. The federal funds rate was hiked by a total of 425 basis points between March 2022 and November 2022, including four consecutive 75-basis-point moves. This aggressive tightening cycle was accompanied by a rapid reduction in the Fed's balance sheet, which had expanded significantly during the pandemic to support the economic recovery.

The impact of these policy adjustments was immediate and far-reaching. Treasury yields soared, with the 10-year yield reaching its highest level since 2023 at 4.80%. Borrowing costs for households and corporations increased, putting downward pressure on equity prices and strengthening the U.S. dollar against other currencies. Mortgage rates, for example, rose as high as 8 percent, from less than 3 percent in early 2021, dampening new borrowing activity and refinancing incentives, and strongly disincentivizing moving and homebuying for households. As a result, existing home sales fell.

But despite these tightening measures, the U.S. economy has shown remarkable resilience. Real GDP growth rates have remained relatively high, consumer spending has been strong, and unemployment rates have been just above historic lows. The 10-year Treasury yield began rising in September, reaching its highest level since 2023 at 4.80%, driven by expectations for both economic growth and inflation, which were higher than anticipated.



However, President-elect Trump's proposed tariffs and immigration policies could threaten to derail the Fed's progress in bringing down inflation. Significant tariffs on imports from Canada, China, and Mexico—the United States’ three biggest trading partners—will push up prices for American businesses and consumers. Throttling immigration inflows and deporting workers will increase costs for key sectors in the US economy, such as agriculture and construction. These cost increases will be passed onto business and consumers in the form of higher final prices.

New and continued tax cuts are likely to lead to larger federal deficits. This will boost aggregate demand without increasing aggregate supply, ratcheting up prices further. President-elect Trump’s push to reduce regulatory burdens might offset some of these price pressures by making it easier for businesses to operate. But, on balance, the Trump agenda is likely to make it harder to get inflation down, which would curtail the Fed’s rate-cutting path.

The Fed's own projections and the minutes from the December meeting of the Federal Open Markets Committee (FOMC) indicate a cautious approach to future rate cuts. The FOMC anticipated risks of higher-than-expected inflation, partly driven by potential tariffs from President-elect Donald Trump, and made a "finely balanced" decision to lower interest rates. Fed Chair Jerome Powell noted that "conditions in the labor market are now less tight than they were in 2019," and that interest rate cuts would occur more slowly in 2025.

In conclusion, while the Fed has made significant progress in bringing down inflation, President-elect Trump's proposed tariffs and immigration policies could threaten to reignite inflationary pressures. The Fed's ability to implement further rate cuts in 2025 will depend on how these policies play out and their impact on the economy. Investors should keep a close eye on these developments and be prepared to adjust their portfolios accordingly.