The trade war has taken a harsher turn, threatening to further dampen economic growth. We expect the Fed to respond with sizable rate cuts, but the timing and amounts are more speculative than normal. Why? Economic data haven’t yet taken a major downward turn, and there’s uncertainty over how the Fed will react.

With news that the US is pursuing sanctions against China and Mexico, the two-front trade war has caused markets to dramatically rethink the economic outlook and monetary policy expectations—more than two rate cuts are now priced in before the end of 2019. In our view, the odds of a more negative economic outcome have indeed risen. The US’s trade relationship with Mexico may be smaller than the one with China, but it’s more important from a macro perspective because of the deeply interwoven supply chain between the two countries.

The use of trade policy as a tool to achieve other policy objectives (immigration policy, in this case) will likely dampen business sentiment and investment, particularly given that a trade deal with Mexico was already assumed to be in the rearview mirror. Even if the threatened tariffs don’t go into full effect, the damage may already be done. Also, Mexico was a potential alternative to businesses that needed to rejigger their supply chain to adjust to tariffs on China; that option is no longer as appealing.

A Negative for US Growth—More So Globally

The US economy is already slowing from last year’s fiscally boosted growth, and many other economies are already struggling, making the intensified trade war a challenging headwind. But it’s not easy to estimate the impact. Financial markets seem to be very pessimistic, with bond markets already pricing in a US recession in the next couple of quarters.

We think that’s an exaggeration. Yes, growth will suffer, but the US has advantages over other economies. The biggest: The Federal Reserve is in a position to respond to a negative growth shock. Policy rates are lower than they were in past cycles—but higher than in almost any other developed country. As we’ve noted, inflation is, if anything, too low. That gives the Fed the leeway to cut rates as needed to support the economy, which should be enough to stave off the most negative outcomes.

Being Aggressive Earlier Might Be the Right Play

Historically, the Fed would wait to respond until it gauged the trade war’s economic impact. Recent messaging supports that notion, which would tend to rule out a rate cut until officials see a run of weaker data. Of course, that approach has left the Fed behind the curve in the past and forced aggressive moves to play catch-up. With the policy rate very low, that prospect isn’t appealing. And with inflation already too low, there’s a strong case for acting earlier, reducing the probability of having to cut rates back to the zero bound later.

The earlier and more aggressively the Fed moves, the more likely it will avoid a more negative economic result. If such a rate cut turns out to be the “wrong” thing to do—if the trade war’s economic impact is smaller than expected, for example—the cost will be trivial, in our view. However, the Fed tends to move slowly and deliberately. Usually, that’s the right thing to do, but we’re not convinced it’s right this time.

Rate Forecast: Focus on the Narrative, Not the Specifics

We think the Fed will try hard to sound dovish in June, making it clear that officials are willing to cut if economic data point to weakness—but it won’t cut yet. Officials will want to see it in the numbers first.

We don’t think it will take much evidence of weakness to spur a cut as soon as July, or September at the latest, however. Pending further Fed guidance, we expect no move in June, a 25-basis-point cut likely in July or September, and a total of 75 to 100 basis points of cuts over the next six to nine months, depending on how heavily the trade war hits the economy.

There’s an important caveat in this forecast: it’s more speculative than usual. First, we’re assuming an economic outcome that we haven’t seen in the data yet. And second, we’re assuming a Fed reaction function that’s still very unclear. Our forecast only catches up to where the market already is: significant rate cuts are already priced in. The market is forward looking, although it’s often wrong. This time, however, we think the odds favor it being correct.

Because the forecast is more speculative, investors should focus more on the narrative than the specific cuts and dates. What matters is that trade policy will slow the economy down and the Fed is likely to respond using the policy flexibility it has. When—and how aggressively—it cuts rates is very hard to calibrate, especially since the data haven’t turned over yet. June’s business survey data will be the next key indicator.

If economic data doesn’t weaken very much, the Fed won’t cut very much—or at all. But if the data tumbles, rates could be cut even deeper than we currently expect. Our forecast splits the difference: we assume a negative impact but not one that plunges the US economy into crisis.

Eric Winograd is a Senior Economist at AB

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.