An Urban's Rural View

When Rising Interest Rates Meet Higher Tariffs

Urban C Lehner
By  Urban C Lehner , Editor Emeritus
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It was a coincidence, surely, that the Federal Reserve’s latest interest-rate increase and President Trump’s latest tariff broadside occurred only a few days apart. Yet a common theme underlies them both, and it can be summed up in a single word: inflation.

Inflation has been hibernating in recent years, allowing the Fed to keep interest rates low even as the economy has recovered from the financial crisis. Now, though, the Fed is seeing signs that inflation is awakening. Higher tariffs would accelerate that revival and force the Fed to raise rates higher and faster.

In announcing the latest rate increase, Fed officials said they expect an annual inflation rate of 2.1% the next couple of years. That’s up from their previous forecast of 1.9% and a tad above their 2% target rate. As long as wage growth continues sluggish, the Fed says it can live with this. But as a precaution the central bank is already pushing rates higher a bit faster than it had planned and laying the groundwork for more aggressive rate raising should inflation start to spin out of control.

The Fed has raised rates seven times in the past couple of years and it is now talking about four increases this year instead of the previously predicted three. Gone from its most recent policy statement was the comforting forecast that rates are “likely to remain, for some time, below levels that are expected to prevail in the longer run.”

As the Wall Street Journal observed, “This amounted to policy makers saying they don’t expect to keep leaning with the economy, and that maybe they will need to start leaning against it” (… ).

Tariff increases are an unwelcome addition to this mix. They are inherently inflationary, both raising prices of imported goods and freeing domestic producers of those goods to raise prices. When imposed on materials like steel and aluminum, they pressure makers of finished products to raise prices, too.

Worse, tariffs drag down economic growth. When consumers must pay more for some things, they have less money to buy others, so demand declines. Meanwhile, businesses that lack the market power to pass on cost increases may end up losing money and even laying off workers.

Take, for example, the experience of Lyon Group Holding, as recounted in a recent Wall Street Journal editorial (… ). Lyon makes lockers at three plants in Illinois and Indiana employing 400 workers. The Trump administration has imposed a 25% tariff on steel imports. Steel, traditionally 45% of Lyon’s cost of making lockers, now costs the company $40.68 per locker, up from $33.90. That turns a $5 per unit profit into a $1.78 loss.

Lyon doesn’t have many American competitors but even before the tariffs its clients were paying 10% more for its lockers than Chinese locker makers were charging. If Lyon raises prices, it will lose customers. To cut costs and return to profitability Lyon’s owner is looking at imported Chinese-made parts, but if he buys them he will have to lay off a fourth of his employees and close a factory.

Lyon, to be sure, is a very small cog in a very big American economic machine. It’s not clear how many other Lyons are out there. It’s not clear how far or how much wider the administration will go in raising tariffs or how big the effect will be. What is clear is that tariffs both raise prices and hurt economic growth. Don't dismiss the possibility that we will stumble into “stagflation”—a nasty combination of inflation and sluggish economic growth that cursed the American economy the 1970s.

If stagflation happens, the Fed will face a conundrum. By law it has a dual mission—keep the economy humming and contain inflation. Stagflation would require it to do both at the same time, an almost impossible trick. Most likely, the bond market will make the decision for the Fed, driving interest rates higher as fixed-income investors demand a better return for taking the risk of being repaid in less valuable dollars. The Fed won’t have much choice but to follow along.

Let's hope this doesn't come about. If it does, farmers and other big borrowers will be among the unfortunate victims.

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Urban Lehner
6/28/2018 | 4:39 PM CDT
Thanks, Paul. I'm afraid no one knows when it's going to end, including the people on both sides of the trade war doing the shooting. There isn't a lot of strategy behind these battle plans.
6/26/2018 | 8:08 AM CDT
Gee, steel manufacturers wouldn't raise the price of their products by 20% just because they can, would they?! :0 Unless this situation ends by the start of fall, I suspect it will be hard to reverse the consequences. Paul Overby