Statement on Monetary Policy – May 20251. In Depth – Global Economy and Financial Markets

1.1 How has global trade policy changed since the February Statement?

Global economic uncertainty has increased substantially, amid significant increases in tariffs.

Since the previous Statement, the United States has implemented higher tariffs on almost all of its trading partners and some economies have introduced retaliatory tariffs. Currently, the higher US tariffs include country-level tariffs starting at 10 per cent, as well as tariffs imposed on specific sectors. The largest increase in US tariffs has been on imports from China – Australia’s largest trading partner – with a current default tariff rate of 30 per cent (Graph 1.1). Exemptions have been put in place for a range of imported goods, including around 15 per cent of Chinese exports to the United States.

Current tariff rates are a long way below the levels initially implemented in early April as higher tariffs have been paused to allow for trade negotiations to take place. The most notable de-escalation has been between the United States and China. The United States initially increased its default tariff rate on Chinese imports to 145 per cent and China had retaliated with a 125 per cent tariff on imports from the United States. These remained in place for some of April and May but were put on pause for 90 days from 14 May. Even after accounting for current exemptions and pauses, tariffs imposed since January 2025 have raised the average effective tariff rate on US imports from around 2 per cent to around 15 per cent. This is the highest level since the 1930s and a much larger increase than the 1.5 percentage point tariff increase in 2018. The US administration has also signalled its intention to impose additional sector-specific tariffs, including on pharmaceutical and semi-conductor imports.

There is significant uncertainty as to how US trade policy will evolve and how its trading partners will respond (Graph 1.2). In some cases, bilateral tariff rates may fall further as negotiations proceed; in others they may rise. The pause on very high US–China bilateral tariffs has driven a small decrease in US trade policy uncertainty, but against the backdrop of temporary pauses and continued negotiations, uncertainty is likely to remain elevated for some time.

1.2 How do higher tariffs affect the global economy?

Persistently higher tariffs would weigh on global growth, though the implications for inflation are likely to vary across countries.

Higher tariffs affect the global economy through a range of channels. In countries imposing tariffs, the cost of imported inputs to production and imported consumption goods will increase. This provides an incentive for demand to shift towards domestically produced goods and away from imports. However, domestic production may be less efficient, as supply chains and the economy’s production structure adjust, resulting in higher intermediate and final prices for a wide range of goods. By disrupting supply chains, reducing productivity and raising costs, tariffs reduce the supply capacity of the economy. At the same time, consumers’ and business’ real purchasing power and spending will decline. While government revenues and profits for some domestic firms may increase, the overall effect is likely to be a reduction in aggregate demand and activity.

In addition to the direct effect of tariffs, trade tensions between large economies can result in significant increases in uncertainty in affected economies and more widely, as is currently the case. That can have a large effect on demand as households increase precautionary saving and businesses delay investment; if higher tariffs are sustained, innovations and technological progress may also slow.

Falls in asset prices, resulting from increased uncertainty and a sharp repricing of risk premia, can further reduce household spending and increase businesses’ cost of funding, lowering growth prospects further. This could be exacerbated if market functioning was impaired.

Due to differences between US tariff rates on China and its other trading partners, global trade flows may adjust to some extent, reducing the impact of the supply and demand shocks. For example, Chinese exports may find new markets, while lower tariffed countries may export more to the United States in place of China. To an extent, these changing trading patterns helped to offset the impact of higher US tariffs in 2018 and 2019, though effective tariff rates and policy uncertainty increased by much less in that episode. The degree to, and speed with, which global trade flows reorient are uncertain and depend on future US trade policy.

The impact on inflation will depend on the timing and severity of the supply- and demand-side effects in each economy, and on movements in exchange rates. The timing of and extent to which businesses pass through the cost of tariffs can also affect how tariffs add to inflationary pressures. In the short run, US tariffs are likely to lead to higher inflation in the United States as the price level adjusts higher. In line with higher market-implied measures of inflation compensation, market economists’ outlook for US inflation in the short term has increased substantially and so have households’ short-term inflation expectations, though most measures of medium-term inflation expectations remain close to the Federal Reserve’s inflation target. The effect on inflation outside the United States is less certain. Weaker global demand will put downward pressure on inflation, while disruptions to global manufacturing supply chains could pose upside risks. The nature of countries’ fiscal and monetary policy responses will also affect the outcome.

A range of indicators will signal how the trade shocks are affecting global trade and economic activity over coming months.

The early effects of the tariff and uncertainty shock are already evident in some timely indicators. Consumer sentiment has declined sharply in the United States and most other advanced economies, although it remains resilient in Australia (Graph 1.4). Business investment intentions have declined in North America but have not shifted much in other advanced economies so far, including in Australia (see Box C: Insights from Liaison). Consumer price inflation in the United States eased in April, with tariff impacts yet to materialise.

A range of data shows that international trade has been resilient thus far, with the exception of trade between China and the United States. Trade data from China showed exports to the United States fell by 20 per cent in April, but this was partly offset by an increase in exports to other countries (Graph 1.5). Official trade data for the United States for April is not yet available, but container traffic data indicated goods imports to the United States remained solid at around their 2024 levels. However, it may take time for trade data to fully reflect current tariff rates as there may be lags between the response of importers to changes in tariff rates and trade flows. In addition, businesses brought forward the import of some goods to mitigate the risk that tariff rates increase after temporary exemptions expire.

As we gauge the likely economic impact of higher tariffs and policy uncertainty in the months ahead, we will continue to closely monitor news on tariff policies and associated policy uncertainty indicators, prices of financial assets and commodities, consumer and business sentiment indicators, and data on supply chains, shipping and trade flows. These indicators will be particularly important as it is likely to take some time for official economic data to show the impact of tariffs due to the usual lags in the publication of data, the potential for some demand to be brought forward and lags between when investment decisions are made and when the investment happens.

1.3 How has fiscal and monetary policy responded so far?

In response to tariffs and trade policy uncertainty, some policymakers, including in China, have adopted a more expansionary policy stance.

Chinese authorities announced a GDP growth target of around 5 per cent for 2025 (unchanged from 2024) at the National People’s Congress in March and have indicated that they are willing to ease fiscal policy further to mitigate the effects on domestic growth of higher tariffs and weaker global demand. The People’s Bank of China (PBC) also eased monetary policy modestly in May by lowering its key policy rate by 10 basis points and reducing the reserve requirement ratio by 50 basis points. Additional funding has also been made available to priority sectors via banks through the medium-term lending facility and structural lending facilities.

Commensurate with this, Chinese Government bond yields have continued to decline since the start of April. Some broader measures of financial conditions have tightened modestly amid heightened trade uncertainty and a softer outlook for growth. Authorities have responded by intervening in the onshore equity market through the purchase of securities by state-backed investment funds to support prices. The PBC has also continued to emphasise currency stability, which limits the exchange rate’s ability to offset the macroeconomic impact of the tariffs.

There has been a material easing in the fiscal stance outside of China. In Europe, leaders have announced their intention to significantly increase defence and infrastructure spending. This includes a major fiscal expansion in Germany, where the parliament has approved a 500 billion infrastructure fund and relaxed the fiscal rules applicable to defence spending. Japan and Korea have also announced fiscal packages to reduce the adverse economic impacts of higher US tariffs.

A few advanced economy central banks have cut rates further while emphasising increased uncertainty affecting the outlook for policy.

The European Central Bank, Bank of England and Reserve Bank of New Zealand have further reduced policy rates in their first meetings following the tariff announcements on 2 April. These central banks highlighted progress on disinflation, while observing that the growth outlook had deteriorated due to trade tensions and emphasising the high degree of uncertainty about the outlook. They communicated further rate cuts would depend on future developments in trade policy and the evolving evidence of the effects on economic activity and inflation. These meetings (and those discussed below) took place before the recent announcement of a temporary reduction in tariffs between the United States and China.

Other central banks left policy rates unchanged. These central banks acknowledged the weaker outlook for growth against a backdrop of prior rate cuts, but some, including the US Federal Reserve (Fed), noted the potential for tariffs to raise inflation in the near term. The Fed communicated there were risks to both sides of its dual mandate and stated that it would wait for further data before considering any adjustments to its policy stance, but could act quickly if needed. The Bank of Canada similarly pointed to high uncertainty, indicating a data-dependent strategy that places less weight on highly uncertain forecasts. Meanwhile, the Bank of Japan kept its policy rate on hold given the high level of uncertainty and noting downside risks to activity and prices, but said it expects to resume rate increases if inflationary pressures do not subside.

Most central banks have emphasised that while monetary policy can offset weaker demand resulting from higher tariffs, it is not an effective tool for addressing any supply-side effects. Some central bank officials have flagged the likelihood that weaker demand will push down both growth and inflation, particularly in economies less directly exposed to US trade and less likely to impose retaliatory tariffs of their own. However, others have highlighted the risk that higher near-term inflation from supply-side disruptions could have a persistent effect if they raise inflation expectations, limiting the ability of monetary policy to offset weaker growth. Market participants appear less concerned by the latter possibility, given the decline in both longer term inflation compensation measures and policy rate expectations.

Market participants expect a modestly lower path for policy rates in response to a weaker growth outlook.

Policy rate expectations declined earlier in the United States than in most other advanced economies, but have recovered some of these declines in recent weeks (Graph 1.6; Graph 1.7). Previously announced tariffs raised expectations that demand would weaken but also result in higher near-term inflation, limiting the scope for market participants to price in further US rate cuts as tariff announcements escalated. Subsequent progress in tariff negotiations has strengthened confidence that tariffs will settle at substantially lower levels than initially announced, while cautious central bank messaging had also reduced expectations of a rapid easing of policy rates. In most other advanced economies, most of the overall decline in policy rate expectations took place following the April announcement. Expectations are now only modestly lower than in February as market participants anticipate that a less adverse outlook for global trade barriers and growth will require less offsetting policy easing.

1.4 How have financial markets reacted to developments?

Pricing in financial markets has been fluid over recent months as market participants have responded to rapidly changing news about trade policy.

Equity prices across advanced economies fell sharply and spreads on corporate bonds widened as risk sentiment deteriorated immediately following the US tariff announcements on 2 April and subsequent retaliation by China. They have, however, recovered following the pause in implementation of some tariffs, supported also by expectations of lower policy rates (Graph 1.8; Graph 1.9). While equity risk premiums and corporate bond spreads have increased slightly from the historically low levels reached earlier in the year, they remain well below long-run average levels across most markets, while expected volatility has subsided from sharply higher levels reached in early April. Overall, financial market participants currently appear to be pricing in some modest downside risks to global growth, but not a significant downturn. This is consistent with expectations that tariffs will settle at a less disruptive level, with trade policy uncertainty also declining, and their negative effects on growth somewhat offset by easier monetary and fiscal policy. However, if outcomes for trade policy or economic developments are worse than currently expected, riskier asset prices could fall sharply, contributing to a tightening in financial conditions.

US equity and sub-investment grade corporate bond prices have declined by more than in other advanced economies in an environment of heightened policy uncertainty and already stretched valuations. Riskier asset prices in Europe appear to have held up better, in part because European growth is expected to be supported by increased fiscal spending. Globally, stocks in sectors that are more exposed to trade and the economic cycle have been among those with the weakest relative performance across most markets in recent months.

Oil prices have declined around 13 per cent since early April, but prices in most other key industrial commodity markets are now little changed.

Global growth concerns weighed on oil and base metal prices following the initial announcement of US tariffs in early April (Graph 1.10). Base metals prices recovered significantly following tariff pauses and expectations of trade deals, but OPEC+ supply increases kept oil prices low. Iron ore prices have remained resilient against the backdrop of the Chinese authorities’ stated commitment to support activity in China; stimulus in China is expected to have a strong investment component.

Short-term government bond yields in advanced economies have declined since the February Statement, though risk premiums on longer term US Treasuries have increased.

The decline in yields on short-term government bonds is consistent with modestly lower expectations for the near-term path of policy rates, while longer term yields have generally increased outside the United States (Graph 1.11). In most economies, measures of inflation compensation have declined, particularly at the short end, as market participants assess that the adverse demand implications of tariff developments will outweigh adverse supply-side effects, and in line with declining oil prices. By contrast, inflation compensation measures in the United States have increased over short horizons (of less than around two years) but declined further out. This suggests that market participants expect tariffs to have a material but short-lived effect on inflation, including perhaps because of an expectation that current tariff policy settings will be reversed.

The term premium on US Treasuries – which measures the compensation investors demand for bearing interest rate and other risk on longer term sovereign exposures – has risen in recent months. This contributed to the sharp increases in yields on long-term US Treasuries during the recent bout of volatility (discussed below), although the modest decline in policy rate expectations means that long-term US Treasury yields are slightly lower than in February. An increase in the term premium is consistent with the rise in economic uncertainty, while some market participants have suggested that concerns from foreign investors about the potential for more persistent uncertainty over US policy settings may also have reduced the foreign demand for US Treasuries.

The US dollar depreciated against most advanced economy currencies, while the euro has appreciated.

After reaching multi-decade highs at the beginning of the year, the US dollar depreciated notably on a trade-weighted basis following the US tariff announcements in early April (Graph 1.12). This contrasted with many previous episodes of heightened uncertainty and risk aversion in financial markets, where the US dollar had tended to appreciate (discussed below). These developments also went against some market participants’ expectations that tariffs would support the US dollar through reducing demand for imports into the United States, which would, in turn, lower demand for other currencies. Some weakening in forward-looking indicators of US activity – which led to downward revisions to US policy rate expectations – have also weighed on the dollar. The euro appreciated over this period, with relative expectations for euro area economic activity supported by expectations of increased fiscal spending. Movements in the Australian dollar are discussed in Chapter 2: Australian Financial Conditions.

In early April, moves in US asset prices and the US dollar departed from the more typical ‘risk-off’ pattern of recent decades, as some investors have sought to reduce US exposures.

Yields on long-term US Treasuries rose sharply alongside the broad-based depreciation of the US dollar on several days around the peak of heightened risk aversion at the start of April. This contrasted with the more common pattern of ‘risk-off’ market moves, where investors sell riskier assets such as equities and buy assets perceived to be safer such as longer dated US Treasuries, driving down the yield. While a depreciation in the US dollar during a ‘risk-off’ event is not unprecedented (e.g. a similar unwinding occurred following the collapse of the US ‘dot-com bubble’ in the early 2000s), the combination of this with large increases in long-term US Treasury yields was unusual by historical standards. Other benchmark government bonds (e.g. in Germany and Japan) experienced much smaller moves in yields than US Treasuries, while gold (another traditional ‘safe haven’ asset) increased in price. Pressure on US asset prices (but not the US dollar) diminished as market stress subsided in the days following the US administration’s decisions to pause some tariffs and enter negotiations with its trading partners.

It is too early to tell whether this episode reflects a lasting view among investors that the degree of safety from US assets may have diminished, as some commentators have suggested. The episode was short-lived and could be explained by more conventional factors such as the unwinding of stretched positioning and the rebalancing of investor portfolios (rather than one motivated primarily by US safety concerns), since many investors were overweight US assets prior to the shock. Information from market liaison suggests that an unwinding of leveraged positions may also have contributed to the rise in long-term US Treasury yields. However, given the key role that US dollar assets, and particularly US Treasuries, play in global funding markets and the management of market participants’ credit and liquidity risks, any lasting shift in investor behaviour towards US assets could increase the risks to market functioning or financial stability in the event of another similar negative shock. A view that the US dollar is more likely to depreciate during these types of ‘risk-off’ episodes could also result in some international investors, who historically relied on an appreciating US dollar to be a ‘natural hedge’ in such episodes, choosing to increase currency hedges on their US dollar exposures; an increase in hedging of this nature reportedly contributed to a sharp appreciation of the New Taiwan dollar against the US dollar in early May.

Liquidity was strained at times, but markets did not experience the dislocations seen in past episodes of significant stress.

Measures of market functioning deteriorated in the days following the US tariff announcements on 2 April, most notably in the United States. Bid-ask spreads widened for both government and private sector securities, and while trading volumes increased, indicators of market depth (which represent the availability of willing buyers and sellers at close to market prices) deteriorated. Strained market liquidity and the elevated level of economic uncertainty contributed to an increase in realised and expected volatility in asset prices. In US equity markets, expected volatility rose to levels only exceeded during the global financial crisis and early days of the COVID-19 pandemic. Concerns about US Treasury market functioning following sharp increases in long-term yields were cited as one factor contributing to the US decision to pause some tariffs. However, markets did not experience the extreme dislocations seen in these previous crises. Since the US pause of some tariffs, liquidity has improved and volatility has subsided. Issuance of corporate bonds has also recovered somewhat from very low levels in early April.