How Central Banks Can Minimize the Damage of Tariffs
There are immediate liquidity problems, and then the choice between lowering inflation risk or supporting the economy. A commentary by Ignazio Angeloni
Donald Trump’s turnaround—temporarily retracting reciprocal tariffs just days after imposing them—is striking but does not change the fundamental fact: the global economy is in serious danger right now. The dynamics leading toward a global recession have been set in motion and will continue to unfold.
A generalized 10 percent levy is exorbitant in and of itself. Tariffs on trade between the US and China—a linchpin of global commerce—are unprecedented. And there are more examples besides.
Thus, even though stock markets initially celebrated, the underlying data remain grim. Further crashes in share prices are to be expected, particularly in less than a month’s time, when the first post-tariff US inflation data will be released and the Fed acts accordingly. The message for everyone involved: keep your seat belts fastened.
What can the authorities do to minimize the risks?
As always, during crises, central banks are on the front line. The primary issue at the moment is ensuring system-wide liquidity.
Players incurring losses—particularly hedge funds—are inclined, and in many cases forced, to liquidate positions in pursuit of liquidity.
They may fail to find it if markets stop functioning and prices do not balance supply and demand; in that situation, they risk collapsing, with possible ripple effects. The central bank must step in to offer liquidity.
Warning bells are already ringing; in US markets in recent days, both equities and Treasury securities have fallen simultaneously, which is highly unusual. Typically, the two markets move inversely. This indicates that traders are selling everything in order to secure liquidity.
The Fed, which for several months has been reducing its securities portfolio accumulated during previous crises (as shown by the chart), has already slowed its sales. The problem is not only American but global: Liquidity crises can occur anywhere and in any currency.
In recent years, central banks have developed coordination tools to address such situations: Domestic currency is supplied in its home market, while on other markets liquidity is provided through currency swap operations between central banks.
This system has functioned smoothly: early in the pandemic, the Fed supplied dollars to the rest of the world—mainly Europe and Japan—in an amount approaching half a trillion dollars in just a few days. The financial system overcame the panic and regained stability. Will it work this time as well?
We can rely on the central banks and their leaders (Powell, Lagarde, Bailey, Ueda, and others), but this safety net depends on a high degree of international coordination—a principle that the new occupant of the White House fiercely opposes.
During crises, the Federal Reserve normally acts in collaboration with the Treasury. Are the conditions for that collaboration in place today? The Fed risks being isolated, with Powell exposed to additional attacks from Trump, which have already intensified in recent days.
Beyond the immediate concern, the central issue becomes how interest rates are managed. This crisis differs from previous ones in how its effects are distributed. The 2008–2009 financial crisis primarily hit the economy from the demand side, whereas the pandemic initially impacted supply. Therefore, the first had a generally deflationary effect; the second was inflationary.
The current crisis is “stagflationary,” producing both inflation (initially, above all in America) and recession (everywhere else, fueled by the uncertainty it generates).
The Dilemma for Central Banks
Central banks must choose between tackling inflation—as their mandate requires—or supporting the economy, a statutory duty that formally applies only to the Fed. Which will they choose?
Fed Chair Powell has already spoken plainly: Priority will be given, he says, to whichever variable diverges most from its target. If that is the guiding principle, controlling inflation will take precedence because it is already above the 2 percent target.
The economy, given the latest data, is still running at full steam. Powell himself has candidly stated that the Fed is in no hurry to reduce rates. We will have to wait and see how trade policies develop and which tariffs ultimately remain in force.
In Europe, growth is weaker, though slightly rising. Inflation is a bit above the ECB’s 2% target. A key difference is that the rate the central bank controls is much lower than in the US: 2.5% versus 4.5%. Thus, the ECB has less room to counter a potential demand drop, having already used some of that space in previous months.
Additionally, Europe’s low rates expose it to criticism from the US administration, which consistently accuses Europe of artificially holding down the euro’s exchange rate, thereby fueling its trade surplus.
This factor will loom large when negotiations on tariffs between the European Union and the US get serious.
It appears the European Union is leaning toward a cautious opening move: proposing the reciprocal elimination of all tariffs, likely with the objective of making the baseline 10% rate permanent.
But this proposal is unlikely to be accepted, both because of the visceral opposition of the current US leadership toward Europe and because they point primarily at “implicit tariffs,” with the euro’s exchange rate front and center.
Reportedly, the ECB is preparing to cut rates at its next meeting on April 17, while the Fed will likely keep rates steady until May, its next meeting date, or perhaps longer. In this environment, a rate cut by the ECB could make an already difficult negotiation even more complicated.
An Italian version of this article was published in the newspaper La Repubblica - Affari e Finanza
IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
