US stocks dropped by more than 2% on 10 October after US President Donald Trump threatened to impose an additional 100% tariff on Chinese exports to the US and more export controls on critical software. Such tariffs could increase the risk of stagflation in the US economy and make life difficult for the US Federal Reserve when it comes to the outlook for monetary policy.
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Donald Trump’s latest tariff threat may just be posturing given that he retreated shortly after threatening to cancel a meeting with Chinese President Xi scheduled for later in October. If, however, the new tariffs do come into effect on 1 November, the implications for global markets could be far-reaching.
For the US, the new levies would raise the chances of the economy slipping into stagnation and higher inflation – stagflation. They could also raise questions over the future path of the Fed’s rate-cut cycle.
For China, there is a renewed risk of faltering growth. This would likely hamper the Chinese stock market’s recovery and put more pressure on Beijing to take more aggressive support measures.
Return of the Sahm rule
Even without the threatened 100% tariffs, the US is facing potential stagflation, as indicated by the ‘Sahm rule’. This economic indicator identifies signals related to the start of a recession when the three-month moving average of the unemployment rate rises by 0.5 percentage points (ppt) or more above its low in the preceding 12 months.
Fed Chair Jerome Powell has acknowledged that for policy decisions, the downside risks to the US labour market weigh more heavily than the risk of higher inflation. This contrasts with his previous view that the Sahm rule was a ‘statistical regularity’ that did not have to result in a recession and, by implication, monetary policy easing.
Something has changed.
The ‘dot plot’ from September’s Federal Open Market Committee meeting now projects two more rate cuts this year and one in 2026. The meeting minutes hinted at further rate cuts down the road despite lingering worries over inflation.
Some market players are even predicting more rate cuts than the dot plot foresees.
What has changed the outlook for the US?
The Sahm rule sent false signals in 2024, with the unemployment rate rising above the 0.5ppt threshold without triggering a US recession (see Exhibit 1). Arguably, last year was exceptional because of strong labour force growth arising from the post-Covid surge in immigration. The massive increase in people seeking jobs exceeded company hiring, boosting unemployment.
That immigration surge is now over given the administration’s deportation policy and a border policing crackdown. As a result, the Sahm rule may yet become relevant.
The Fed’s policy dilemma
The US labour market has indeed weakened, with job openings continuing to fall off. Employment is increasingly harder to find, according to the Job Openings and Labor Turnover Survey (JOLTS) and Conference Board data.
Somewhat paradoxically, output appears to have remained resilient, with US second-quarter growth being revised up to 3.8% annualised, supported by private consumption growing at 2.5%.
However, with the highest US tariffs in decades set to fuel inflation and crimp growth in the coming months, the Fed is stuck between a rock and a hard place.
The latest (August) unemployment rate was 4.3%. Using Sahm rule metrics, this translates into a three-month moving average of 0.5ppt above the low point of 3.8% of the past 12 months. This underscores the Fed’s concern over increasing downside risk to the labour market.
However, even before Trump’s latest tariff threat, inflation expectations had already risen (see Exhibit 2), implying a risk of inflation un-anchoring. This concern has kept the Fed cautious on cutting US rates further.
Productivity to the rescue?
Weakening labour market conditions and rising growth are incompatible unless productivity rises. The spreading use of artificial intelligence (AI) could allow companies to hire fewer people and still expand production, which would also help explain impressive recent gains in corporate profits.
Indeed, IT budgets have shifted massively towards AI, helping to boost productivity since the pandemic (see Exhibit 3). The capital stock of tech industries – computers and peripherals, communication equipment and semiconductors – jumped by 50% between 2019 and 2024, according to industry data.
The AI investment theme is expected to continue.
At the same time, core inflation has remained stuck well above the Fed’s 2% target.
In theory, the US central bank should accommodate a positive supply shock with lower interest rates so that demand could catch up with expanding supply.
However, inflation would have to fall to convince policymakers that productivity has indeed shifted higher. This has not happened so far, and the tariffs are complicating the inflation picture.
The Fed’s forgotten mandate
It is worth remembering that the Fed has a statutory third (largely ignored) mandate to promote moderate long-term interest rates, as stipulated in the 1977 Federal Reserve Reform Act. President Trump’s newly appointed Fed Governor Stephen Miran cited this third mandate in a Congressional hearing in September in his effort to push for lower interest rates.
Bringing this into focus has raised market concerns that the White House might use monetary policy to influence longer-term bond yields. In addition, worries over the Fed’s independence are hanging over the markets. If the Fed were to suppress bond yields at the long end of the curve when inflation is above target and economic growth remains resilient, the bond market could sell off and compromise Fed policy.
Such risk needs monitoring, not least because Chair Powell is due to step down in May 2026 and many investors are wondering whether a Trump acolyte will replace him.
