President Donald Trump’s ongoing trade wars and “stop-go” policy threats and actions are damaging the global economy, and the UK is not an exception. Bank of England interest-rate setters are not oblivious to these threats. Costas Milas writes that protecting the UK economy from damage is a big challenge ahead.
President Trump’s tariff wars are constantly in the news. As Figure 1 demonstrates, a Google search of “tariff wars” indicates a notable rise of worldwide interest over the past few months.
Figure 1. Tariff wars, Google search, worldwide
Over the past few days, Trump has threatened with a 200 per cent tariff on imports of alcohol from EU countries, on top of a previous announcement of 25 per cent tariffs on steel and aluminium imports. US supermarkets and restaurants would surely (and desperately) look for alternatives. One obvious solution would involve US retails trying to stock and sell more wine produced in the US. But the US is currently the fifth largest exporter of wine in the world, with Canada being the biggest importer of wine from the US. Consequently, keeping exports “at home” would surely be a huge challenge for US producers (exporters).
That said, ancient history provides some (absurd) lessons. Having established itself as a particularly important centre of long-distance trade, the ancient Roman Empire city of Palmyra, in today’s Syria, pursued a policy of imposing tariffs on its exports (yes, exports!) of olive oil and animal fat. This way, Palmyra ensured that sufficient quantities of food and goods would remain in the city for consumption. Imposing tariffs on exports of US wine would be an absurd measure for Trump to implement which, of course, flags how irrational and unpredictable all these trade wars are becoming.
Trump’s “stop-go” trade policies are undermining the health of the global and UK economies. The National Institute of Economic and Social Research (NIESR) predicts that higher US tariffs would reduce global GDP growth by around 1 per cent over the next two years, whereas UK GDP could be up to 2.5 per cent lower after three years. Having contracted by 0.1 per cent in January 2025, the UK economy will, nevertheless, “battle” Trump’s trade wars starting from a very fragile state.
Let us look more in detail at the possible impact of US trade policies on the UK. In figure 2, I plot a measure of US uncertainty together with business investment growth in the UK. My US measure is a “pooled” proxy of US economic policy uncertainty and trade policy uncertainty. From Figure 2, uncertainty is at its highest level since 1997. Notice the inverse relationship between uncertainty and business investment growth in the UK. This should not come as a surprise: the higher economic and trade uncertainty, the less willing firms become to invest, at least until the uncertainty fog is lifted. This, in turn, impacts negatively on the creation of jobs, tax revenues and economic growth in the UK.
Figure 2. US uncertainty and business investment growth in the UK
To illustrate further, Figure 3 plots together US uncertainty and the UK output gap measure from the Office for Budget Responsibility (OBR). A positive output gap indicates that the UK economy over-performs relative to its potential (or historical trend), whereas a negative output gap suggests that the UK underperforms compared to its potential. Again, there is a negative relationship between uncertainty and the state of the UK economy.
Figure 3. US uncertainty and UK output gap
How about the ongoing worry that Trump’s trade wars, followed by a retaliation from other countries, would increase global and UK inflation? Figure 4 plots US uncertainty together with predicted inflation in the UK. Using data from the Bank of England’s Monetary Policy Report, I construct a weighted average of the Bank of England’s one-year and two-year ahead predicted inflation (with a 70 per cent weight on the one-year-ahead inflation and a 30 per cent weight on the two-year-ahead inflation). There is a positive but very tiny correlation (of only 0.13) between the forecast of UK inflation and uncertainty which seems to suggest that trade wars might only have a mild impact on future UK inflation. I also plot the median long-term (over five years) expectations of inflation based on survey data. The latter also has a positive but, nevertheless, mild correlation (of 0.18) with US uncertainty.
Figure 4. Inflation forecast and US uncertainty
If trade wars do have an impact on UK inflation and economy growth, it makes sense for interest-rate setters in the Bank of England to “monitor” uncertainty when making interest rate decisions. Existing academic research has, in fact, established a link between interest rates and uncertainty. More to the point, Central Banks appear quite worried about the contractionary impact of uncertainty on output developments, which outweighs the possible inflationary impact of uncertainty. To the extent that this is true, policymakers might be tempted to cut interest rates when uncertainty is on the rise.
To see this, I plot, in Figure 5, the Bank of England’s main policy rate together with US uncertainty. Notice the inverse relationship: higher uncertainty co-exists with a lower Bank of England policy rate. The figurearguably understates the strength of the inverse relationship because in period of elevated uncertainty, such as the 2008-2009 financial crisis, the Bank of England pursued quantitative easing policies rather than setting negative interest rates.
Figure 5. US uncertainty and Bank of England’s main policy rate (bank rate)
This should not necessarily come as a surprise. In recent academic research, jointly with Georgios Papapanagiotou, I found that international economic uncertainty is able to predict future inflation, GDP growth and interest rates in the UK. In fact, my latest estimates, based on an “interest rate reaction function” that takes into account forecasts of inflation, the output gap and the measure of (trade) uncertainty discussed here, suggest that elevated uncertainty since early 2024 (the pace of which accelerated since the election of Donald Trump in November 2024) has contributed to a reduction in the Bank rate by 50 basis points in total.
The current “stop-go” policy intentions of Trump are fuelling international uncertainty and impacting negatively the UK economy. The promising news is that these policies are considered, and rightly so, by the Bank of England’s interest-rate setters. Nevertheless, the Bank is faced with additional challenges related to the UK’s own statistical agency. The Office for National Statistics has admitted errors in its price measures and trade data. Here comes the challenge: If the ONS cannot accurately measure export and import prices then the Bank of England will have huge difficulty in monitoring the impact of the (ongoing) trade wars on import(export) prices and, consequently, on UK inflation.
Faced with this challenge, the Bank’s policymakers might decide to delay any further interest rate action until data uncertainty is tackled. This will be equivalent to treating the UK as a “closed economy” which is economically flawed. That is, by possibly opting for policy inaction, the Bank will seriously underestimate the impact of Trump’s trade wars on the UK economy and arguably end up way behind the curve in trying to tackle both inflationary and recessionary pressures.
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