The U.S.

and China Will Probably Work It

Out
Trump needs a trade deal to ensure a healthy economy.

By
Bill Dudley

They can do it.

The U.S. and China keep escalating a trade war that markets had expected to be over by now.
How will it ever end? Actually, as I see it, the prospects for a benign outcome remain quite
good.

Market participants have long assumed that the two sides would reach a deal involving
modest concessions from China -- such as steps to increase imports, improve U.S. firms’
access to Chinese markets and toughen protection of intellectual property rights. Instead,
trade tensions have increased, with the U.S. threatening to impose a 25% tariff on the
remaining $300 billion of Chinese imports not yet subject to tariffs. And it could get worse:
U.S. President Donald Trump’s demands have backed Chinese President Xi Jinping into a
corner, leaving little room for the latter to make a deal without losing face.

At first glance, the trade standoff might not seem terribly consequential for the economy. As
matters stand today, U.S. tariffs on Chinese imports have increased by $30 billion a year,
which will in turn impose added costs on U.S. consumers. This is the equivalent of a small
tightening of U.S. fiscal policy that will depress demand and elevate prices slightly.

Ultimately, though, the effect on U.S. demand will be much greater than $30 billion. That’s
because uncertainty about what comes next will lead businesses to delay investment. It’s hard
to decide how to configure your global supply chain if you don’t know whether or how the
rules of the game might change. The uncertainty also adds to anxieties about a U.S. recession,
weighing on stock prices and tightening financial market conditions.

I see three potential paths forward. First, both sides concede that a trade war is not winnable
and eventually reach a deal of modest consequence. The U.S. unwinds tariffs, reversing the
fiscal tightening, reducing the damaging uncertainty and restoring confidence in the
economic outlook. If I were in the president’s shoes, this is the outcome I’d want because it
offers the best chance of reelection.

Second, the sides stay in a holding pattern. Trade negotiations don’t resume, but nobody
escalates. President Trump’s threat of a 25% tariff on the remainder of Chinese imports
remains no more than a threat -- as has happened with tariffs on European car imports. It’s
still out there, but keeps getting pushed into the future. In this case, the economy and markets
remain somewhat stressed. But over time, uncertainty subsides as people increasingly assume
that this is how matters will remain.

Third, the trade war escalates further and the U.S. carries through on its threat of more tariffs.
In this case, the impact on the U.S. economy becomes significant. Higher import prices boost
inflation, and added fiscal tightening markedly increases the risk of a recession. Worse, China
retaliates, with more negative consequences for the U.S. economy and stock market.

There’s not much the Federal Reserve can do before it knows which of the three scenarios
will prevail. This reinforces its inclination to keep interest rates on hold. Officials would
likely view the increase in prices as a one-time event, unless it somehow triggered more
persistent wage inflation. That said, I suspect that Fed economists see the potential impact of
uncertainty on activity as the more significant risk at this point. So if Trump goes further
down the escalation path, it’s certainly possible that the Fed will cut its short-term interest-
rate target by 0.5 percentage point over the next 12 months -- as futures markets currently
expect.

More likely, though, Trump will back off, because the U.S. economy’s performance is too
important for his reelection prospects. Without progress toward a deal, the chances of a
politically disastrous recession increase. Better to take that risk off the table.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP
and its owners.