Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching Canada's Tariffs
Transcript
- Lucas: Look, if you’ve been watching the headlines this week, the story isn’t just about interest rates anymore. It’s about the sudden, sharp escalation between the United States and Canada. As of yesterday, we have confirmed reports that Washington has revealed an import ban on a slew of Canadian goods, while Ottawa immediately followed through with retaliatory tariffs worth CA$27.6 billion. That is not a minor diplomatic spat. That is a structural shock to one of the most integrated supply chains in the world. Luna: Right, and what makes this particularly dangerous for the Fed is that these aren't just consumer goods sitting on shelves. These are intermediate inputs. Auto parts, aluminum, specialized machinery components. Lucas: Exactly. And here is the concrete thing you can take away today: when you tax intermediate goods, you are effectively taxing American manufacturing efficiency. The cost doesn't just disappear; it gets baked into the final product. If a Ford plant in Michigan has to pay a tariff on Canadian steel or software services, that raises their marginal cost. And if they pass that on to consumers, you get inflation without any increase in domestic demand. That is the nightmare scenario for Jerome Powell right now. Luna: It feels like the Fed is being squeezed from both sides. You've got sticky domestic services inflation, and now you're adding an external supply-side hit. Lucas: Let's look at the data we have as of early morning on September 9th, 2026. The Fed Funds effective rate is holding flat at 3.63 percent. But look at the Core PCE price index. It came in at 130.7 for July, up from 130.34 in June. That is a persistent creep. When you combine that baseline stubbornness with fresh trade barriers, the margin for error shrinks to almost nothing. The market is already reacting. The ten-year Treasury yield, which I track closely, is sitting at 4.83 percent, ticking up over the last five days. Luna: So the bond market is pricing in that the Fed can't cut rates anytime soon, maybe even worrying they'll have to hike again if inflation re-accelerates. Lucas: Precisely. The bond vigilantes are whispering. And before we go deeper into the mechanics of how this affects your wallet, I want to pause for a second. If walking through the economy with us has made something click, the way these stay ad-free is listener support. You can buy me a coffee dot com slash fexingo. It helps keep the research sharp and the commentary honest. Luna: Yeah, and honestly, having the bandwidth to dig into these trade flows instead of just chasing daily noise is exactly what that support enables. Lucas: Thanks for considering it. Now, back to the meat of it. Let's talk about the specific mechanism here. Why does the Fed care so much about a trade dispute with a neighbor? Usually, they focus on the labor market or domestic consumption. But this is different because the U.S.-Canada trade relationship is vertically integrated. We don't just trade finished cars; we trade half-finished cars back and forth across the border multiple times during production. Luna: So a tariff hits the same part twice. Once when it goes north, and again when it comes south. Lucas: Double taxation on efficiency. That is the key phrase. When you disrupt that flow, you aren't just raising the price of a widget. You are increasing the volatility of production costs. And the Fed hates volatility. They prefer predictable inflation. If manufacturers can't forecast their input costs because of unpredictable tariff regimes, they raise margins preemptively. That leads to a wage-price spiral risk that didn't exist six months ago. Luna: It also complicates their forecasting models. The Fed relies on projections that assume certain baseline conditions. A CA$27.6 billion tariff environment breaks those baselines. Lucas: Right. And look at the broader context. China's imports in August also missed estimates, signaling a global rebalancing that is slowing overall trade volumes. Meanwhile, Japan's foreign reserves dropped by a record $80 billion in August due to yen intervention. The global monetary system is stressed on multiple fronts. The Fed isn't operating in a vacuum. They are watching how capital flows react to these trade wars. Luna: So if the dollar strengthens because of safe-haven flows or higher yields, does that offset some of the import inflation? Lucas: That is the classic counter-argument. A stronger dollar makes imports cheaper in local currency terms. So theoretically, the tariff cost is partially absorbed by the currency move. But here is the catch: the tariffs are specific to Canadian goods, not all imports. And the U.S. import ban targets specific sectors where substitutes aren't readily available. You can't just switch from Canadian lumber to Brazilian lumber overnight. The logistics, the quality standards, the contracts—they are rigid. So the pass-through to consumer prices is likely faster and more complete than the currency hedge can mitigate. Luna: Which means the Core CPI, currently at 332.8, could see another bump in the next report. Especially in housing-related costs if construction materials get taxed. Lucas: Spot on. Housing is a huge component of the CPI. If lumber, drywall, or specialized fixtures become more expensive due to cross-border frictions, shelter costs rise. And shelter costs are sticky. They don't fall quickly. So even if energy prices drop, the overall inflation number stays elevated. This forces the Fed to keep the federal funds rate at 3.63 percent, or potentially higher, for longer than the market expects. Luna: It’s ironic. The people who wanted tougher trade leverage might be getting exactly what they asked for, but at the cost of their own purchasing power. Lucas: That is the political economy trap. Short-term leverage for long-term inflation. And the Fed has to deal with the long-term reality. They can't print money to subsidize the inefficiency caused by tariffs. They have to let the pain work through the system via interest rates. Which brings us to the bond market reaction. The S&P 500 is down 0.3 percent over the last five days, but the Dow is down 1.1 percent. Industrial stocks are getting hammered. Investors are realizing that earnings forecasts need to be revised downward for companies with heavy North American exposure. Luna: So it's not just macro numbers. It's corporate margins getting crushed. That feeds back into layoffs or wage stagnation, which eventually cools demand. But it takes quarters to play out. Lucas: Exactly. And that lag is why the Fed is cautious. They are watching the ten-year breakeven inflation rate, which is currently at 2.37 percent. That is above their 2 percent target. If trade wars push that breakeven rate higher, it signals that long-term inflation expectations are unanchoring. And once expectations unanchor, they are very hard to bring back down. You saw what happened in the early 1970s. It starts with a shock, and it ends with a decade of stagflation. Luna: We probably won't go that far, but the fear is real. What about the smaller companies? The ones that don't have the hedging power of Apple or Microsoft? Lucas: That is the vulnerable piece. Small businesses operate on thinner margins. They can't absorb a 10 percent tariff on raw materials like a multinational can. They either go out of business or they raise prices aggressively. If they raise prices aggressively, you get localized inflation spikes. And since small businesses employ a massive chunk of the workforce, any disruption there hits the labor market. The JOLTS data and NFP reports will start showing cracks in hiring if these supply chain costs bite deep enough. Luna: So the Fed is essentially playing defense against a self-inflicted wound. They have to keep rates high to fight inflation, even though the inflation is partly caused by policy choices they didn't make directly, but which affect their mandate. Lucas: Yes. And it highlights the limits of monetary policy. The Fed can raise rates to cool demand, but they can't fix a broken supply chain. If the problem is cost-push inflation from tariffs, rate hikes actually hurt growth without solving the root cause. You get lower growth and still-high inflation. That is stagflation-lite. And historically, that is the worst environment for equities and bonds alike. Luna: It makes the current market volatility feel justified. The VIX might be quiet today, but the underlying tension is building. Lucas: I think so. And let's not forget the international spillover. Japan intervened heavily in August, dropping reserves by $80 billion. If the U.S. trade war escalates, it could trigger broader protectionism globally. Other countries might retaliate against U.S. exports. That hurts American agriculture and tech giants alike. It turns a bilateral dispute into a multilateral headache. The IMF and ECB are watching this closely. Global coordination is fracturing, and the Fed is the anchor. If the anchor drags, everyone gets pulled under. Luna: It really changes the calculus for investors. You can't just look at the Fed Funds rate in isolation anymore. You have to model the geopolitical risk premium. Lucas: Absolutely. And that risk premium is already showing up in the ten-year yield at 4.83 percent. Investors are demanding more compensation for holding U.S. debt because the economic outlook is cloudier. So, for listeners trying to navigate this: cash is king in uncertainty, but high-quality bonds with short duration might be safer than long-dated treasuries if inflation ticks up further. Luna: Or diversifying into assets that benefit from inflation, like commodities, though those are volatile too. Lucas: Commodities are tricky. If a trade war slows global growth, demand for copper and oil drops. So you might see deflationary pressure on commodities even if consumer prices are rising due to tariffs. It’s a divergence that confuses models. But the lesson remains simple: stability is valuable. And right now, stability is in short supply. Luna: It’s a reminder that economics isn't just about numbers on a screen. It's about politics, relationships, and the real-world friction of moving goods across borders. Lucas: Exactly. And as we head into the next FOMC meeting, watch the language. If Powell mentions 'external factors' or 'supply chain disruptions' more frequently, consider it a warning shot. The Fed is preparing the market for a hawkish hold. The path ahead is narrow, and the trade war just widened the obstacles. Luna: A narrow path with potholes added by tariffs. Thanks for breaking this down, Lucas. Lucas: My pleasure. Keep an eye on the Core PCE data next month. If it jumps, the Fed's hands are tied. If it holds, we might still have room to breathe. Until then, stay curious.