Divergence in Monetary Policies amid the Trade War

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Dr Ru Xie, University of Bath

The recent announcement from US president Donald Trump to impose new tariffs of $200bn on Chinese goods has intensified the US - China trade war. Unlike previous tariffs, which are targeted at businesses, the latest taxes will directly hit thousands of consumer goods. The imposition of a trade tariff raises the relative price of foreign goods in the US, and also this rise in (import) prices  raises the cost of current consumption relative to future consumption. Both of these effects will lead to movements in real interest rates and the real exchange rate.

When the US imposes trade tariff on Chinese imports, the internal prices of goods rises in the current period in US. This will inflate the cost of current consumption and, in turn, put upward pressure on US real interest rate, as the US Federal Reserve will seek to dampen inflationary pressures. This in turn will lead to a depreciation of  the Chinese Renminbi (RMB). A small depreciation can make Chinese exports more competitive and mitigate the impact of trade tariffs. However, if aggregate demand is price inelastic, a depreciation in the RMB might not help much. On the other hand, a depreciation in the RMB will raise the cost of imported goods into China and affect Chinese industrial production. In general, trade tariffs can temporarily push up inflation and move the real exchange rate ratio, making it harder for central banks to adjust monetary policies accordingly.

In line with the current monetary policy normalisation process – that is, raising interest rates, reducing large-scale asset purchases, and shrinking central bank balance sheet - the US Federal Reserve announced a further hike of interest rates by 0.25% on the 26th September 2018. Over the past three years, the central bank rate in the US has interest rates from zero to over two percent with expectations of further increases in the pipeline. In response to the recent Fed rate increase, China’s central bank left interest rates unchanged to maintain low domestic borrowing costs. The two central banks’ monetary policies exhibit a divergence amid the trade war, largely due to different domestic economic and monetary conditions. The U.S. economy is growing at a faster pace this year than previously forecasted. A tighter monetary policy will strengthen the US dollar position and induce a pickup of capital flows into the US, as investors seek to benefit from higher yields and the possibility of capital gains from currency movements. On the other hand, China has been easing credit policies and trying to reduce funding costs to stabilize growth. An expansionary monetary policy will help to boost real spending and investment by facilitating an increase in the supply and demand for liquidity. Raising interest rates does not fit with China’s current economic strategy to stimulate consumption and investment.

The US Fed rate rise and the lack of a Chinese response results in a narrowing of the interest rate differential between the US and China. In addition, as the US dollar appreciates, the Chinese market might become less competitive and experience deteriorations in its current-account position. Historically, actual and potential capital outflows have forced central banks to raise local interest rates, which intensifies economic contractionary pressures and inflates corporate funding costs. At the same time, a devalued domestic currency could boost inflation and the cost of foreign debts dragging an economy into a recession. However, China maintains strict controls over exchange rate and capital flows, giving it plenty of policy space to implement fiscal and monetary policy tools to handle the pressure. The trade tariff combined with a US Fed rate hike have piled some pressure on Chinese economic growth in the short term. However, in the long term, a prudent monetary policy with ample liquidity supply and other fiscal and monetary policy instruments will provide flexibility to absorb the external shocks and help China to maintain economic growth and financial stability. In the long run, we may expect to see a re-balanced global trading system and global financial system by better global policy coordination to avoid vicious business cycles.


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