If the US and China can't agree on trade, the Fed may need to cut rates after all

Investors on Monday bet the United States and China would reach a trade resolution. But if the countries fail to come up with a deal, we got a glimpse at what could happen — and it could be ugly.

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Paul R. La Monica
, CNN Business
CNN — Investors on Monday bet the United States and China would reach a trade resolution. But if the countries fail to come up with a deal, we got a glimpse at what could happen — and it could be ugly.

Markets' initial reaction to President Donald Trump's threats to impose higher tariffs on China sent stocks tumbling around the globe Monday. The Dow fell as much as 471 points.

Although investors ultimately changed their minds, refusing to believe the bluster, the Monday morning plunge should send a message to Trump: Be careful what you wish for, Mr. President.

Trump has frequently called on the Federal Reserve to cut interest rates now in order to boost the economy and the stock market — a kick many experts don't think is necessary.

If Trump goes through with his threat and market chaos resumes, one can't help but wonder whether the president might eventually get the rate cuts he's asking for — just with a trade war as the catalyst.

If Corporate America's giants start to take an earnings hit, there could be major consequences. Revenue and earnings growth could slow. Stocks could slide. Companies could react by cutting costs, which often means layoffs.

Add all that up and the Fed may suddenly start to worry that lower interest rates are needed in order to prop up the job market.

Trade war could hurt the job market

Trump on Sunday threatened to raise the 10% tariff on $200 billion worth of Chinese goods to 25%, and suggested new tariffs could also be in the works. If China retaliates with higher tariffs of its own, such a move could eventually hurt scores of companies that do big business in China, including Dow components Apple, Boeing, Caterpillar, Coca-Cola and McDonald's.

Trump seems to be of the mindset that the United States has the upper hand in its trade negotiations with China, since the US economy and stock market have been holding up well. He might be correct, but the good news can't last forever.

The market rally to start off the year seemed to show how much Wall Street began to dismiss much of Trump's rhetoric. But it's hard to read this president.

"The challenge for investors is deciphering whether this another bluff by the president, an attempt to lower expectations in order to provide an upside surprise or actually a potential breakdown of the trade negotiations and an escalation of the trade war," wrote Mike O'Rourke, chief market strategist with JonesTrading, in a report.

Deflation now. Inflation later?

After maximum employment, the Fed's other mandate is price stability, or keeping inflation in check. Prices haven't been rising all that much lately, and there are some who worry that the lack of any significant inflation could be another reason that the Fed may have to shift gears and cut rates.

Katie Nixon, chief investment officer with Northern Trust Wealth Management, calls this "stuckflation" — a persistently low increase in prices.

The biggest fear is if that "stuckflation" becomes deflation. That drop in prices could cause businesses to hold off on investments and consumers to slow their spending and wait for prices to fall even further.

Ironically, a trade war could finally bring about higher prices, since US consumers would be paying the price of increased tariffs on foreign-made goods. That could hurt consumer spending and economic growth, too — in other words, another challenge that could backfire on Trump and lead the Fed to lower interest rates.

"We believe the U.S. economy will slow down as the year proceeds," JPMorgan Funds chief global strategist David Kelly wrote in a note to clients Monday. "While the Fed may feel very comfortable in ignoring calls for rate cuts today, those calls might make them more inclined to concede rate cuts later in the year."

Compounding the issue, Kelly added that cutting short-term interest rates would probably make economic weakness even worse. He noted that people would start to worry more about the possibility of a recession, which could create a self-fulfilling prophecy.

Markets are the Fed's third mandate

It's increasingly appeared as if the Fed has an unofficial third mandate: making sure investors remain happy.

Fed chair Jerome Powell has often mentioned as a concern the fact that financial markets have become more volatile. In particular, Powell has talked about global "crosscurrents" that threaten to derail growth in the United States and big foreign markets.

Powell, for better or for worse, has become the world's financial traffic cop -— making sure that everyone keeps moving along without causing any crashes in the process.

That means the Fed may be forced to cut rates if a global stock market rout threatens to turn into a worldwide economic slowdown. It won't matter if the US economy and market aren't hurt as badly as China's.

There will still be pain, but it will more likely be inflicted by the White House's trade policies, not the Fed. The central bank will be forced to clean up the mess.

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