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S&P: Fed may cut rates if trade war depresses domestic demand

The trade dispute between the U.S. and China will push consumer prices higher, and if the rift results in a "meaningful slowdown" in U.S. domestic demand, the Federal Reserve may cut rates, S&P Global Ratings said.

Higher prices as a result of increased tariffs will help bring the overall inflation reading closer to the Fed's target, but the U.S. central bank would likely see it as temporary unless domestic demand slumped.

The Fed is currently sticking to its "wait-and-see" stance, but the chance of an "insurance" rate cut has increased, S&P Global Ratings said May 22.

U.S.-China trade tensions are likely to have minimal direct macroeconomic effects on the world's two largest economies for the rest of 2019, but the tussle may impact other economies, like Germany, France, the U.K., some Nordic nations and Canada.

The share of European content in U.S. production is twice as high as it is in Chinese production. "The indirect effects in Europe could be more detrimental, not least because it is increasingly dependent on trade, unlike China, and much more dependent than the U.S.," according to the rating agency.

However, Canada may benefit from the trade war, which could divert U.S. purchases from China to Canada, resulting in Canada's exports to the U.S. jumping as much as $20 billion.

"The bad news is that Canada will likely suffer collateral damage as the tariffs sour business sentiment and put planned investment at risk — though there will probably be little effect on Canadian GDP growth," according to Rob Palombi, S&P Global Ratings' Canadian chief economist.

Direct effects are also expected on countries with a high share of exports to China, such as Chile and Peru.

S&P Global Ratings reiterated that the 25% U.S. tariffs imposed on China, along with retaliation from China, will trim about 30 basis points from U.S. GDP in the next 12 months, while China's GDP may lose about 0.1 percentage point.