Make no mistake, that the Trump tariffs and exchange rate shocks constitute a triple whammy of demand, supply and terms of trade shocks. So far, the Trump’s strategy seems to be rooted in the fiscal devaluation literature. It believes that the tax policies can replicate the effects of currency devaluation. Fahri, et. al. (2014) had shown that the economic effects of exchange rate devaluation can be perfectly replicated by combination policy of an import tariff and an export subsidy.

Europe, which along with Asia and Canada, now faces the brunt of tariff adjustments, had itself toyed with the use of fiscal devaluation. The ECB suggested it for countries which ran persistent CADs but did not have the option to devalue in a Monetary Union.

It is likely that after the (i) tariff actions prior to the L-day and (ii) half the reciprocal tariffs on the L-Day, the end game may come in the form of (iii) US offering reduction in tariffs against a signed or unsigned participation in Mar-a-Lago accord on weakening dollar akin to the Plaza accord.

Trump made tariff increase announcements on 17 dates prior to the L-Day covering several geographies. These prior actions included 25 per cent tariffs on Canada and Mexico, additional 20 per cent tariff on China and 25 per cent tariff, steel, aluminium, and auto imports worldwide.

Retaliation so far has been swift but measured in some cases. Canada had retaliated but Mexico has been relatively restrained. EU is all set to escalate retaliatory tariffs beyond the initial tariff hikes.

According to a study published by Du and Shepotylo in March 2025, the worldwide impact of tariff actions prior to auto and L-day tariff hikes was estimated at $1.4 trillion. This appears to be an underestimate though it already amounts to 1.3 per cent of the global nominal GDP. With several moving parts any estimates may be ineffective for calibrating exact monetary and fiscal policy responses.

China has now additionally levied 34 per cent reciprocal tariff on all US products in response to the same tariff imposed on it by the US on L-Day.

A misnomer

L-Day tariffs were half the US calculation of reciprocal tariff, but the US calculations had nothing to do with tariffs. It is a misnomer to call them reciprocal tariffs as they directly target trade deficits. Their calibration, however, can cause significant dampening effect on global trade and global growth besides being inflationary.

By its very nature, macroeconomic policies find it hard to address stagflation. Actions to revive growth are inflationary and actions to tame inflation engineer slowdown. Optimal monetary policy response to the tariffs is, therefore, hard to crystallise.

Inflation targeting frameworks prioritise controlling inflation to growth as that is what monetary policy can do best. However, supply shocks that open large output gaps can prompt central banks to use more flexibility than built into the frameworks, leaving chances of policy mistakes.

Moreover, inflation targeting central banks, especially in emerging markets (EMs), face serious trilemma problems. They will find it hard to manage exchange rates and will need to astutely calibrate policies to slacken at least one of the goals of exchange rate stability, independent monetary policy and free capital flows.

They may face sudden stops or reversals of capital flows. Bond yields will fall steeply across geographies, except perhaps in the US as it may find it harder to rollover public debt once Asia’s saving glut evaporates and their central banks stop building reserves. However, some portfolio reallocations away from emerging markets where risk premia will rise sharply may cushion this effect.

The inflationary shock in EMs like India may be far more muted if after facing a 26 per cent tariff, it does not engage in a tariff war but benefits from the possible collapse of global commodity prices. It may make good sense if the RBI stays with an expected 25 bps rate cut on April 9. Liquidity deficits have been addressed, so a 50 bps CRR cut appears to be a stretch. A 50 bps repo rate cut at this stage will be risky as the monetary space is limited and will need to be used later.

After all, the Reserve Bank raised policy rates a meagre 250 bps in the last tightening cycle that started in May 2022 and lasted 9-months. This was in sharp contrast to a lot more aggressive monetary tightening by almost all other central banks. Having already cut policy rate by 25 bps to 6.25 per cent, with one-year ahead expected inflation at 4.2 per cent, the real policy rate hovers around 2 per cent leaving the scope for only one 25 bps rate cut to take it to neutral rate.

At the same time, given that the plunging stock markets, especially in Asia and high likelihoods of real estate prices falling with a short lag, the negative output gap will gradually turn disproportionately large. With the inevitable slowdown of the global and the Indian economy, odds are that inflation will remain around 4 per cent except in case of a tail risk event that involves the Houthis and Iran attempting to target oil assets in UAE, Kuwat and the Saudis.

Monetary policy stance

Therefore, on April 9, the MPC can well consider making the monetary policy stance accommodative with a state-contingent forward guidance that in a rapidly shifting economic and geopolitical environment, the central bank will stand ready to shift stance should inflation risks rise, or excessive exchange rate volatility so warrants. A possible 50 bps CRR can best be timed at a stage when liquidity dries out in money markets off the monetary policy scheduled dates,

Thankfully, if going gets worse, aggressive fiscal consolidation of 5.5 per cent of combined deficit in the last four years will come handy for fiscal stimulus. However, it too has to be moderate with an expansion of no more than 2 per cent of GDP lest it will make debt unsustainable.

Lastly, the monetary authorities in EMs should resist temptation to undertake beggar-thy-neighbour devaluations as dollar weakens. They should maintain exchange rate flexibility and lean against the wind if Mar-a-Lago causes strong and continued dollar depreciation causing exchange rates to deviate from fundamental equilibrium. Also, before it becomes too late, RBI should put in place a framework for some macro-prudential measures in its forthcoming monetary policy.

The writer is Professor at IIM Kozhikode and a former RBI ED and MPC member. Views are personal

Published on April 7, 2025