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Could the Fed Support the Economy in the Trade War?

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The US-China trade war, in its second year, is only intensifying. Donald Trump, in a tweet on August 23, asked US companies to find an alternative to China.

The trade war escalated in May when the US levied a 25% tariff on $250 billion in Chinese imports. This move slowed US GDP growth to 2.0% in the second quarter from 3.1% in the first quarter, according to the US Bureau of Economic Analysis. As a result of the slowdown, the Fed cut interest rates by 25 basis points in July.

The trade war is now escalating further. Trump is set to impose a 15% tariff on another $300 billion in Chinese imports on September 1 and December 15. This round of tariffs is to include consumer goods, which could impact US consumers.

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US consumer likely to suffer because of the trade war

Tariffs increase the cost of Chinese products. China has tried to mitigate the impact of tariffs by depreciating the yuan, but that could hurt the Chinese economy. The costs of higher tariffs will ultimately be borne by the customer. Even if companies produce goods in the US, production costs would rise and be carried over to US consumers. Some US companies have shifted their production from China to countries where production costs are lower than they are in the US. However, shifting production entails more costs for the companies, hurting their gross margins. Moreover, manufacturing yields would initially be lower.

Tariffs on consumer goods reduce overall demand and slow economic growth, in that slower consumer demand reduces companies’ revenue. A decline in revenue impacts companies’ cash flow and increases their inventories. As a result, their production and orders fall, impacting their suppliers. In August, the US manufacturing PMI fell below 50 for the first time since the 2009 financial crisis. A reduction in manufacturing means job losses.

To encourage US businesses and consumers to continue spending, Trump is asking the Fed to cut rates by 100 basis points in the short term to revive economic growth. However, economists are not in favor of such aggressive rate cuts.

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Economists say the Fed cannot bail out the economy

Trump doesn’t seem likely to back down on the trade war, despite the presidential election coming up next year. Economists believe the Fed shouldn’t bear the consequences of the trade war.

On August 23, Reuters reported that Economic Outlook Group chief global economist Bernard Baumohl said, “Don’t ask the Federal Reserve to bail out the economy, because they’re not going to be able to do it this time.” To understand this statement, we should look at the Fed’s interest rate cut limitations.

As explained by MarketWatch, the Fed has fewer rate cut opportunities than it has had in the past. The Fed started its rate-cut cycle with 550 basis points in 2001, and reduced that to 500 basis points in 2007. The Fed reduced the interest rate to 0.25 basis points in December 2008 and maintained this rate until December 2015. Over the next three years, the Fed increased the rate to 225 basis points. In July 2019, the rate cut cycle started with 225 basis points. MarketWatch estimates that the Fed has only eight rounds to bring the rate to zero. That forecast is based on interest rates being cut by 25 basis points in every instance.

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Trump is demanding a 50-basis-point cut, which could bring the rate to zero in just four instances, even when the US economy is nowhere close to recession. The US stock market is near its all-time high, unemployment is still at a 50-year low, and the GDP is still growing. Although it may be too early for the economy to hit a recession, the risk of recession is increasing.

What choices does the Fed have?

On August 27, former New York Fed president William Dudley wrote in a Bloomberg post, “Central bank officials face a choice: enable the Trump administration to continue down a disastrous path of trade war escalation, or send a clear signal that if the administration does so, the president, not the Fed, will bear the risks — including the risk of losing the next election.”

On the same day, CNBC reported that the Fed had refused Dudley’s request. A Fed spokesman stated that the Fed’s policy decisions aren’t influenced by political considerations, but rather aimed at stabilizing inflation and maximizing employment.

If the Fed reduces the interest rate by 50 basis points, it could avoid short-term market disappointment. However, such an aggressive rate cut could indicate that the Fed acknowledges the risk of a recession, creating panic in stock markets.

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What a Fed rate cut means for semiconductor stocks

The semiconductor industry has been the hardest hit by the trade war, as China is the manufacturing hub of most consumer electronics. Many US semiconductor companies supply components to China, and some also import finished goods from China. Therefore, US semiconductor companies are more prone to China’s retaliatory tariffs than US tariffs.

The trade war slowed Chinese demand and encouraged some Chinese companies to find alternative suppliers. Almost all US semiconductor companies’ revenue has fallen year-over-year because of the trade war. Many semiconductor companies are seeing reduced orders from customers. Furthermore, memory chipmakers have reduced their capital spending to bring supply in line with demand. Many have shifted their production outside China.

A rate cut could help chip companies secure financing at a lower cost and invest that money in their business. Any significant rate cuts could also encourage companies to restructure their debt to reduce their interest burden, thereby improving their profit. The VanEck Vectors Semiconductor ETF (SMH) rose 2.17% yesterday when China stated that it would not retaliate. Meanwhile, Advanced Micro Devices, NVIDIA, Intel, and Qualcomm stocks all rose more than 2%.

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