Nations with more policy space can better allay US tariff impact: BMI

Economies with more policy space like Germany and Indonesia are better positioned to mitigate potentially adverse tariff effects. In contrast, those with limited policy space, such as Japan and Brazil, may struggle to respond effectively.

There are also economies like France and China that fall in between, with a mix of higher and lower policy space.

Tariff shocks could prompt central banks to reduce interest rates to bolster economic activity while managing the risk of tariff-induced inflationary pressures.

In this scenario, the more the current policy rate exceeds the pre-COVID five-year average—measured by the basis point (bps) gap—and the closer inflation is to the target, the greater the flexibility policymakers have to respond decisively to an economic downturn.

Under this framework, the European Central Bank, and central banks in Australia and Canada potentially hold the most substantial ‘monetary firepower’ among major developed markets. This is due to their inflation rates being around target, allowing for a greater reduction in interest rates compared to their counterparts.

Conversely, the Bank of Japan, with a spread of just 56 bps and an inflation rate of 4 per cent—which is double its targets—would have the most limited maneuvering space, constraining its ability to adjust monetary policy in response to economic challenges, BMI noted.

The United States and the United Kingdom occupy a middle ground; they could significantly reduce interest rates before reverting to their 2015-2019 levels. However, above-target inflation could limit policymakers' ability to cut rates as much as the policy rate spread metric might suggest.

For emerging markets, the situation is more nuanced, as the external position of the economy plays a critical role in influencing policymakers' monetary decisions.

Inflation being at target and having a sizeable interest rate spread are not sufficient conditions to provide policymakers with the policy latitude they might need.

External position dynamics, such as current account deficits, also play a crucial role in effectively constraining the available policy space. A current account surplus grants central banks greater flexibility to lower interest rates with reduced concerns about currency depreciation and capital outflows. In contrast, a current account deficit necessitates more cautious policy adjustments.

Considering these factors, Mexico would enjoy the amplest maneuvering space among its peers, as it satisfies all three conditions: inflation near target, a substantial interest rate spread and a current account surplus.

Conversely, China has relatively less capacity to use monetary policy to bolster growth. Despite a strong current account surplus, China's policy rate is already 263 bps below its 2015-2019 average, and with inflation at just 0.5 per cent year on year in February, the Chinese economy is expected to experience disinflationary conditions.

Romania, Poland, and Brazil would also face constrained monetary space due to above-target inflation and weak external positions.

South Korea, Germany and Australia possess greater fiscal space compared to their peers, owing to both lower-than-average government debt and narrower fiscal deficits. In contrast, the United Kingdom, France, and especially Italy and Japan, face higher-than-average government debt and budget deficits, constraining their flexibility to reduce taxes or increase public spending to counteract recessionary pressures.

Among the sampled emerging market economies, Indonesia, Vietnam and Mexico stand out with greater fiscal space relative to their peers, as they maintain both lower-than-average government debt and narrower fiscal deficits. These conditions provide them with more flexibility to implement fiscal measures to support their economies.

Conversely, China, Brazil and India are challenged by higher-than-average budget deficits and elevated government debt levels, which limit their capacity to implement counter-cyclical fiscal policy measures.

ALCHEMPro News Desk (DS)