Speaking before the Economic Club of New York recently, Richard Clarida, Vice-President of the Federal Reserve, drew a positive picture of the US economy. Over the past four quarters, real GDP growth has averaged 3.2%, while the unemployment rate verged on a 50-year low of 3.6%. Month after month, job creations are still going strong. The Federal Open Market Committee (FOMC) is projecting growth of about 2% for the next three years. Clearly, all seems to be going for the best in the best of all possible worlds.

Really? With the sharp drop in 10-year bond yields and Wall Street in May, the US financial markets seem to be signalling the exact opposite. This discord arises from the fact that Mr. Clarida is speaking about the past, while the markets – which have already priced in the US economy’s recent performance – are turned towards the future. Market expectations are what determine the day-to-day dynamics of prices in the equity and bond markets.

The selloff in the equity market and the flight to safe havens such as US Treasuries can be interpreted as reflecting a downward revision of growth assumptions, a reassessment of the probability of various risk scenarios (in this case, the upturn in investors’ risk aversion reflects fears that worst-case scenarios are a little less improbable), or simply a decline in the level of conviction attributed to these forecasts.

All three interpretations lead to the same conclusion: economic prospects are no longer looking quite as upbeat as in the past. There is no shortage of explanations: the delayed reaction to monetary tightening, the upturn in the dollar’s effective exchange rate, the economic slowdown in the rest of the world, the waning impact of the 2018 fiscal impulse, and the intensification of trade tensions. James Bullard of the St. Louis Federal Reserve Bank recently highlighted the dangers of ongoing trade tensions: the US economy is slowing, and as the uncertainty sweeping the world economy intensifies, this slowdown could prove to be more severe than expected. Inflation and the market’s inflation expectations are still holding below the central bank’s target rate, which justifies cutting key rates.

Mr. Clarida did not go quite as far, but he did point out two factors that could push the Fed to act: 1) inflation sustainably below target, and 2) certain developments in the world economy and in the financial markets that pose a major risk for the Fed’s central scenario. Rather ironically, a key rate cut triggered (in part) by the headwinds arising from the escalating US-China trade war would boil down to answering President Trump’s exhortations last month for the Federal Reserve to “help win the trade war” by lowering key rates.

This brings us to the big question of the effectiveness of monetary easing, for both the economy and the markets. In the triangular relation between interest rates, growth prospects and risk aversion, reducing key rates normally ends up boosting growth prospects and reducing risk aversion, bolstering the confidence of economic players and investors. When there is relatively little potential to lower key rates, as is currently the case, the monetary policy transmission channel risks getting bogged down. When there are other major sources of uncertainty present, the effectiveness of monetary policy becomes all the weaker, not to say non-existent.

Unfortunately, there is nothing theoretical about the current situation given the high level of trade tensions, which were further exacerbated recently. These tensions have neutralised, at least in part, the favourable influence on growth of the classic fundamental factors, including household disposable income, corporate earnings, real interest rates and access to financing. If the US-China confrontation persists in the long term, the ensuing headwinds risk reversing these factors, and a rebound in unemployment or a decline in corporate earnings could end up eroding end demand. Fighting a combination of high trade uncertainty and weakened fundamental factors would be challenging, especially given the rather limited manoeuvring room for lowering key rates.