As the financial markets worry about a broadening of US tariffs on imported goods from China and possibly Mexico, the Federal Reserve is debating the appropriate policy response to the developing trade shock. 

The key question is whether it will view the shock mainly as a contraction in demand, or as an adverse supply shock (akin to the 1973 oil shock), which could raise consumer prices by a full percentage point. It is coming round to the view that it can ignore the inflationary risks from higher tariffs and cut policy rates as an insurance against rising recession risks. This is similar to what it did in 1995.

The markets emphatically see the trade war as a global demand shock that will reduce output growth without raising inflation. The policy response is unambiguous. Interest rates should be reduced, perhaps pre-emptively, in order to mitigate a future slowdown in growth. This is why the front end of the US bond market now prices in a reduction in policy rates in July, and an overall cut of 100 basis points before the end of 2020.