Between a shock and a hard place: Trade fragmentation and Monetary Policy – speech by Swati Dhingra

I am delighted to deliver the Dow lecture. Last time I was here at NIESR, there were significant events occurring in international trade. Today, I am going to revisit some of them and discuss the new developments that have taken place since then. The timing is opportune - not just because of how the world trading system is evolving around us.

I have just returned from a regional visit to the border city of Newry in Northern Ireland. There are few places in the world where the importance of international cooperation to the wellbeing of communities is as starkly apparent. And where NIESR is having an impact through its global modelling.

What might Newry have to do with NIESR? NIESR has contributed to developing an all-island economic modelling tool for Northern Ireland, the United Kingdom and the Republic of Ireland. And some of the inputs to this tool will also be part of my lecture today in thinking through the ways in which international economic integration affects the UK economy.

We live in an era of deep economic integration, where goods and services cross borders at an unprecedented scale. However, in recent years, the political consensus around globalisation has started to fracture.

For a small open economy like ours, the global trading system shapes what families and firms purchase, what gets produced domestically, and the nature of our jobs and productivity. Ultimately, it affects the level and distribution of living standards.

In this lecture, I will discuss how our trading relationships shape our economy, particularly in these times of heightened geopolitical tensions.

Historical Overview and the New Slowbalisation

This is not the first time the world has faced a turning point in trade policy. The history of global trade is marked by expansion and retrenchment—periods of openness followed by retreat.

Let’s start in the 19th century, when Britain stood at the forefront of globalisation. The Industrial Revolution, coupled with advances in transportation, allowed goods to move across borders like never before. However, this era of openness did not last. The political instability following World War I and a worldwide economic downturn led trade policy to turn inwards. Nations engaged in protectionist policies, imposing tariffs, restricting imports, and depreciating their currency. These "beggar-thy-neighbour" policies (Robinson, 1937) were intended to expand domestic growth by subsidising domestic production at the expense of domestic consumption.

Global integration increased again after World War II, as nations recognised the need for economic cooperation to foster stability and prosperity. The General Agreement on Tariffs and Trade (GATT) in 1947 set the stage for a new era of economic integration (Bagwell et al., 2020; Irwin and Bown, 2015). Over the following decades, tariffs and trade barriers fell and bilateral and regional trade agreements integrated more countries into the world economy. This trend accelerated in the late 20th century, as technological advancements and geopolitical changes fuelled a wave of “hyperglobalisation”. Improvements in transport technology and digital communication and the formation of major trade blocs (the European Union, NAFTA, and ASEAN) transformed the global economy. Global value chains allowed companies to source labour and materials from multiple countries, reducing costs and increasing efficiency. Between 1986 and 2008, the ratio of world trade to world GDP nearly doubled (Antras, 2020). Supply chains stretched across continents and economies became even more intertwined.

Chart 1: Globalisation is marked with periods of openness and retreat

Trade intensity of world GDP ^(a)

Global trade has since slowed, a shift some call "slowbalisation". While this trend is evident in aggregate trade numbers, it is not uniformly apparent across countries. One significant factor in the overall slowdown is the changing composition of the global economy, with emerging market economies (EMEs)—which tend to have lower trade intensity—playing a larger role in global output. Alongside this, many of the forces that previously fuelled rapid trade expansion seem to have diminished. Global trade has reached a natural deceleration from the rapid expansion that defined previous decades. This is largely driven by the slowdown in the expansion of global value chains, a key driver of trade growth in previous decades (OECD, 2023). Global demand has also shifted toward sectors that rely less on imported inputs, primarily through reduced demand from China and India (Goldberg and Reed, 2023).

Globalisation has slowed down, but it has not reversed. In fact, it has evolved into new forms of integration. Trade in goods peaked in 2008, and trade in services and digital work now make up more than a fifth of export earnings globally (Baldwin et al., 2023). These new forms of globalisation are often not included or underreported in common measures of openness.

With digital technology enabling remote work across borders, the end of globalisation may still be far off. But public sentiment and policy attitudes toward globalisation have become less favourable, with rising protectionism and efforts to reshore production dampening global integration. These shifts are now reflected in trade growing faster within geopolitical trading blocs rather than between them.^{footnote [1]}

Evolving Impacts and Perspectives on Economic Integration

Economic integration can make everyone better off as countries specialise and overall economic activity expands. Trade benefits UK consumers through lower prices and access to a wide variety of goods and services from abroad. At the same time, workers and businesses benefit from access to export markets that increase sales and imported inputs that raise productivity. Trade allows the UK to specialise in industries where it holds a comparative advantage. Through these channels, increased trade raises output, incomes and living standards.

These gains from trade and specialisation have been recognised for centuries, since at least the work of David Ricardo. The rise of modern manufacturing has strengthened the case for international integration through the economies of scale and competitive forces that come with an expansion in market size (Krugman, 1987). In recent decades, studies have further shown that global value chains can amplify the traditional gains from trade, through forward and backward linkages across sectors (Antras and Chor, 2022). More recently, a key development has been the rise of services trade. The UK has played a leading role in global services markets, and this has resulted in greater productivity growth at home.

However, not all forms of globalisation are beneficial. Many economists have highlighted the inequalities, lobbying, tax avoidance and other risks posed by “hyperglobalisation” and the management of the world trading system (Rodrik, 2019, Damgaard et al., 2019, Stiglitz, 2016). And the hopes of trade promoting better institutions across the world are being actively questioned.

Although sentiment towards globalisation had already started to shift in the early 2000s, protectionist views on trade policy have become more prominent since about the global financial crisis. Studies of voting patterns suggest that while exposure to trade and immigration co-exist with other factors, such as automation, technological changes and public policies following the financial crisis, they have nonetheless contributed to the political “backlash” against globalisation in the last few years (Colantone et al., 2022).

Chart 3: Voter choices and trade policies have become less pro-trade

Cumulative vote shares by party groups (left) and trade policy measures (right) ^(a)

• (a) Lines in the chart to the left display five-year moving averages of vote shares by ideological group in all countries covered by the analysis of the source below. Bars in the chart to the right display the number of trade measures classified as trade-restrictive or trade-liberalising by the sources below. Source: Colantone et al. (2022) and Global Trade Alert.

The premise that free trade enhances economic prosperity is being challenged, as many integrated economies have seen inequality increase since about the 1980s. The gap between the winners and losers of exposure to global competition widened. Government transfers triggered by trade shocks were scarce, and those who lost out from globalisation therefore did not receive adequate compensation for their losses (Dorn and Levell, 2024). Income losses from globalisation can become even more problematic when the economic gains are concentrated in a single country. If a country develops a competitive advantage in high-value industries that were once dominated by more advanced economies, then there would be losses for advanced economies in an integrated global market (Samuelson, 2004). Today, some think this concern might be playing out as emerging markets move up the global value chain, expanding beyond low-cost manufacturing into high-tech sectors and services. 

The distributional consequences of globalisation have contributed to widening disparities across social groups and regions, which has led to a noticeable shift in trade policy attitudes across the United States and Europe, with the Brexit referendum marking the first major shift (Colantone et al., 2022). The 2016 Brexit referendum changed our established trading relationships, reducing our level of integration with the European market.

The decision to leave the European Union had immediate economic impacts through a large depreciation of sterling, which translated into higher consumer prices and reduced nominal and real earnings (Breinlich et al., 2022, Costa et al., 2024, see Dhingra and Sampson, 2022 for summary). Subsequently, the exit from the EU has been most visible in goods trade where high value-added manufacturing and small businesses have experienced slower export growth (Norris Keiller, 2024, Freeman et al., 2024). The overall impacts on economic activity are currently hard to quantify due to the confounding effects of the pandemic and the war. But signs of services exports being adversely affected by reduced integration are starting to emerge (Bhalotia et al., 2023).

The shift in the trading relationship with the European market, though significant, has had a relatively limited impact on overall price stability. While food products affected by new trade barriers with the EU experienced price increases after Brexit, these did not translate into broad-based inflationary pressures (Bakker et al., 2023 and Monetary Policy Report, 2024). However, since 2021, global shocks have caused inflation to surge sharply, highlighting the importance of the international trading system for price stability in the UK.

Chart 4: Sterling depreciated sharply on the night of the Brexit referendum
Real wages grew more slowly in sectors that were more exposed to this depreciationSterling depreciation (left) and real wage growth by depreciation exposure (right) ^(a)

• (a) Minute by minute exchange rates (to the left). Real wage growth over 12 months in sectors with below and above median imported input-weighted sterling depreciation (to the right).
• Source: Costa et al., 2024 and reproduced in Dhingra and Sampson, 2022.

Chart 5: Inflation spiked following the sterling depreciation from the referendum

Price growth in excess of rate in June 2016, headline CPI and FNAB ^(a)

Chart 6: Goods exports of small firms to the EU fell after Brexit.
Food Prices rose more in items with greater trade barriers with the EU after Brexit.% Export to the EU (left) and Proportion of Food Price Rising in orange (right) ^(a)

• (a) Event study estimates showing percentage changes in trade with EU relative to the rest of the world by firm size quintile. Firm size measured using average employment between 2013 Q1 and 2015 Q5 (to the left). Quintile 1 denotes the smallest firms and quintile 5 the largest firms. CPI Food Item Prices (to the right) are binned by EU import shares. Up to 40%, 40-60%, 60-80% and over 80%. Lines are the proportion of prices rising and falling m-o-m. Source: Freeman et al, 2024. Updated version from Richard Davies, originally in Bakker et al., 2022

The World Economy and Inflation in the UK

The openness of the UK economy means that inflation is particularly sensitive to changes in imported costs. These costs are shaped by both global export prices and changes in the sterling exchange rate. Since late 2021, the sharp rise in foreign export prices – driven by supply chain disruptions, the war in Ukraine, and strong US consumer demand for goods – has pushed UK import prices higher, causing CPI inflation to rise well above the MPC’s 2% target (Monetary Policy Report, 2024).

Integration with the global economy broadens the range of goods and services available to UK consumers, both in terms of availability and affordability. Dependence on international pricing extends beyond what consumers buy directly however. Domestic production relies on imported inputs, the prices of which have a direct bearing on how much consumers must pay for final goods and services. Taking into account the structure of domestic production, energy and imports of other goods and services make up about forty percent of the UK consumption basket. Energy alone represents 8.5% of this total, compared with 5.1% in the Euro Area (Dhingra, 2024, see Dhingra and Page, 2023 for methodological details).

The extent of our dependence on global energy prices and imports, as opposed to domestic factors – wage costs, firm surpluses and taxes - can be seen in their contribution to headline inflation. Energy and imports of other goods and services contributed 10.8 of the 16.8pps in headline CPI inflation in 2022 (compared to prices in 2019). Even after the surge in energy prices had subsided in 2024, roughly a third of headline inflation could be attributed to global factors. This was not only true for headline inflation – core inflation, services inflation and core services inflation have higher shares of domestic costs embodied in them, and still, 20 to 30 percent of the rise in these measures in 2024 could be attributed to energy and imports of other items.

Energy and imports (excluding energy) have been important contributors to variations in CPI inflation throughout the last two decades. And as the multiple shocks from the pandemic and the war have been unwinding, inflation is falling back from its peaks with global prices growing less slowly than before.

Chart 8: Energy and imports of other items were 10.8 of the 16.8 pps of cumulative CPI inflation (since 2019) in 2022 and still 8.6 of the 24.7 pps in 2024

Pp. contribution to change since 2019 Q4 (as of 2022), (as of 2024) ^(a)

• Source. ONS price indices and supply-use tables.

New Global Trade Policies

After a sharp recovery from the pandemic, the world economy has stagnated and its future growth will depend on how global trade is affected by the significant shift in US trade policy. Economists generally agree that while tariffs can increase US domestic production and government revenue, over the long term, they may also lead to higher import prices and potential job losses in export sectors subject to retaliatory tariffs. However, there is less clarity on the impact of new tariff proposals on other countries. The potential consequences for the UK will depend on how much we directly rely on the US for exports, imports and investments, and the indirect effects of US tariff policy on global markets.

Impacts on UK inflation

Our reliance on imported consumer goods from the US, along with the imported inputs used in their production, makes households vulnerable to global price shocks. While tariffs imposed by the US and other trade partners would directly increase import costs in those countries, their impacts in the UK would depend on how firms in those countries pass on those additional costs to the UK market.

What we buy from US producers is likely to become more expensive as they look to pass on some of their increased costs from US tariffs to UK buyers. But what we buy from firms that export to the US is likely to become less expensive as these exporters look for new markets to divert their products to. Given the significant role of the US in the world economy, tariffs of the proposed magnitude are likely to prompt firms that export to the US to lower their prices to retain demand for their products.

In theory, inducing exporters to reduce their prices is the main rationale for large economies to impose tariffs. Large economies, such as the United States, can benefit from terms-of-trade gains when tariffs reduce their demand for imports, prompting firms that export to them to lower their prices. Evidence from the first round of Trump tariffs presents a mixed picture. Chinese exporters generally did not lower their export prices in response to tariffs during the initial phase, resulting in US importers bearing most of the cost. However, exporters of commodities such as Chinese steel— that rely heavily on competitive pricing in the US market —reduced their pre-tariff prices by as much as 50 per cent to maintain their global market share (Amiti et al., 2019). Over the different phases of tariffs imposed during the first Trump administration, World Bank estimates suggest foreign producers reduced their prices by 8 to 18 percent (World Development Report, 2020). If Chinese exporters of steel, chemicals, and other key intermediate goods adopt a similar strategy, UK manufacturers would see reductions in the prices of their imported inputs. This would work against the direct price-increasing effects from any retaliatory tariffs imposed by the UK or from increased costs passed through by US sellers to the UK market.

Overall, whilst the US is the UK’s largest individual trading partner, it accounts for only around 10 per cent of UK goods imports. And the main imports include crude and refined oil that are unlikely to experience cost increases on account of US tariffs. The direct price-increasing effects from US tariffs to UK prices therefore would be less than feared. The broader indirect effects through global markets and trade diversion are more likely to dominate and to reduce prices in the UK. Whether these price adjustments will have inflationary impacts is a relevant question for monetary policy. Tariffs are likely to create one-off adjustments in prices, rather than inflationary persistence. This was the UK experience after the first round of Trump tariffs (Monetary Policy Report, 2018) and broader evidence suggests that tariff shocks on imported inputs typically do not translate into persistent inflation (IMF research, 2024). Sectoral vulnerabilities however will be important in determining the transition of the economy to the reorganisation of international production networks.

Sectoral vulnerabilities

While the share of the consumption basket adversely affected by US tariffs is small, worryingly, pharmaceutical products are a key import from the US and there have been concerns that the US relies heavily on China for some pharmaceutical products that may be severely disrupted (Graham, 2023, de Bolle, 2024). This could pose hardship for affected families in the absence of alternative sources of supply.

On the export side, the US is the top destination country of UK exports and economic growth in specific industries would be directly affected by new trade barriers. During the US-China trade war of Trump’s first term, UK exports to the US were relatively resilient, growing approximately 10 per cent more than others, but against the backdrop of a 25-30 per cent contraction in total US imports (Fajgelbaum et al., 2024). However, certain UK industries remain vulnerable through their dependence on countries that could be affected by new trade policies. This is especially true for automotive manufacturing, which relies on Chinese components, as well as electronics and pharmaceuticals, which have rigid supply chains involving specialised intermediate goods and critical minerals (Butlin, 2025).

The rapidly evolving nature of new proposals adds considerable uncertainty to global trade dynamics, with potentially tangible economic consequences. Evidence suggests that US investment fell by about 1.5 per cent in 2018 as a result of trade policy uncertainty (Caldara et al., 2020). Similar uncertainty today could slow UK economic growth (particularly in high value-added export sectors) and contribute to a drag on global economic growth.

Risks of Global Economic Fragmentation

The speed and extent of retaliation expands the scope of tariff impositions, laying the groundwork for a broader escalation of trade barriers. When the U.S. imposed tariffs on steel and aluminium in 2018, China retaliated within a couple of weeks with targeted tariffs on US exports with political significance. The EU responded in about three weeks of its tariff exemptions being withdrawn by the US (Butlin, 2025). If such tariff impositions and retaliatory actions proceed in an orderly way, countries will be able to undertake a deliberate and systematic reconfiguration of trade relationships. While relative prices and economic activity would need to re-adjust to new trading realities, inflationary pressures would remain relatively contained through targeted tariffs and countermeasures. Increased trade barriers would dampen income growth and put offsetting downward pressure on prices from increased trade costs (Ambrosino et al., 2024).

If heightened tariffs precipitate stricter barriers on the foreign content of imported goods, global supply chains could fracture along geopolitical lines, with far-reaching consequences for economic growth. A disorderly fragmentation, where countries scramble to secure alternative suppliers, would risk triggering inflationary pressure in the short term and constraining economic growth in the long run.

In the extreme scenario, several large economies deciding to impose trade barriers similar to those proposed by the US, would put severe strain on a few sources of supply. Price spikes and volatility would arise as economies lose diversified supply relationships, particularly in critical inputs (Attinasi et al., 2024). These could amplify into broader inflation through the increased complexity and interdependence of supply chains (Carvalho et al., 2020).

But this seems too extreme a scenario. Current reports suggest that large economies, such as the European Union, are looking to negotiate with the US administration and hence the world economy seems to be moving closer to an orderly fragmentation, possibly of a milder form than one with very punitive countermeasures.

The appropriate monetary policy response to trade fragmentation will need to be calibrated based on the specific trade policies and countermeasures implemented. The scope and duration of their impact on economic activity and inflation will be contingent on the timing, magnitude and nature of trade policies. Beyond tariffs, monetary policy will need to account for exchange rate dynamics and financial conditions that will be affected by spillovers from the US.

Based on the movements seen on days with tariff announcements recently, the dollar would be expected to appreciate in the short term. This is a key price-increasing channel for studies that have modelled the impact of US tariffs on the UK economy. A number of studies have taken some or all the channels – trade, exchange rates, financial conditions - into account to model the impacts of US trade policy on economic outcomes, such as trade, inflation and GDP. Though the models differ in details, they all tend to project a negative impact on UK GDP, ranging from modest effects in the macroeconomic modelling of trade with input-output linkages of Saussay (2024) and Tamberi (2024) to substantial drops in UK GDP in the structural NiGEM simulations of Kaya (2024).

Quantitative macroeconomic trade models have the advantage of rich modelling in global value chains. Their projections point to the transport equipment sector as a key driver of the negative output effects for the UK economy. Modelling a 60% rise in US tariffs on China and a 10% US tariff on other countries, Tamberi (2024) finds modest effects of less than half a percent on import and export prices in the UK.^{footnote [2]} However, trade models do not have additional features such as exchange rate determination and financial conditions, which also contribute to growth and price dynamics.

How trade flows and exchange rates are modelled makes a big difference to the inflation projections for the UK across different models. NiGEM simulations suggest CPI inflation in the UK would rise substantially. This is largely driven by a sharp sterling depreciation, which is fully passed through to import prices. In contrast, in the ECB-Global model, which allows for a more pronounced role for trade diversion, sterling appreciates and the overall impact of US tariffs is projected to reduce inflation in the UK.^{footnote [3]}

In my view, while the longer-term impacts on the dollar are unclear due to the uncertainty of the policy mix and associated risk perceptions, a strengthening of the dollar in the short term would have some price-increasing effects through imports. The dollar is the single most important currency of invoicing for UK imports, making up about 35 percent of all imports. But sterling makes up about 27 percent of imports and the Euro another 20 percent. Dollar movements would affect bilateral exchange rates across many major currencies, and the net magnitude of dollar strengthening will likely be muted through the reliance on other currencies.

On the overall impact on inflation in the UK, the direct effect of US import costs and dollar strengthening are likely to be offset by reduced global price pressures. Trade diversion away from the US would reduce global price pressures for the UK and the dampening of global economic activity from increased trade barriers and uncertainty would also subdue international price growth.

Trade Fragmentation and Monetary Policy

Trade fragmentation increases the complexity and unpredictability of the operating environment for central banks. While monetary policy is well-equipped to manage demand-driven inflation, it is less effective in countering supply-side disturbances. The balance between supply and demand matters for inflation and, consequently, for interest rates.

At times, the magnitude and duration of these supply and demand effects can be challenging to assess in real-time, especially when shocks occur concurrently or in quick succession, making their individual effects difficult to isolate. For a small open economy like the UK, this balance is influenced not only by domestic conditions but also by global economic forces. To underscore the UK’s sensitivity to global economic fluctuations, over the past fifteen years, at least 50 percent of variations in UK GDP growth are estimated to have been driven by global shocks rather than purely domestic factors.

For the UK therefore, trade fragmentation can pose complex challenges. The impacts on activity and inflation will depend on the precise implementation of trade policies and the extent of retaliation. Additionally, fiscal and monetary policy spillovers from the US would have knock-on effects on sterling and financial conditions in the UK. If the world economy fragments in an orderly way, monetary policy would likely not need to respond while the world economy transitions and prices re-adjust to reflect the new geopolitical developments.

If the world economy were to fragment in a less orderly way, supply disruptions could become more frequent and severe than in the past, making sectoral price changes more significant for aggregate inflation. If fragmentation is motivated by geopolitical considerations, critical supply chains may also be weaponised, increasing volatility and price pressures. The recent cost-of-living crisis suggests that sectoral price spikes would have first-order effects on inflation.

In a world where external supply shocks become more prevalent, an independent monetary authority with a clear inflation target is essential. Even outside of extreme scenarios, monetary policy action alone however is not well-suited to address systemic price shocks in key sectors such as energy and food. It may even be counterproductive, as it could constrain investment that would enhance supply resilience and exacerbate future vulnerabilities.

Assessing the need for monetary policy action would require careful evaluation of the nature of the fragmentation shocks, their sectoral impacts and the time horizon over which they would be expected to unwind. This would not be feasible without improved analytical tools and a better understanding of supply chains and trade interdependencies using granular data (Attinasi et al., 2024). Central bank reviews are putting these tools and strategies on their agenda and the heightened geopolitical tensions have made this more urgent.

I would like to thank Jenny Chan and Donal McVeigh for their help in the preparation of these remarks.

I would also like to extend my thanks for helpful comments and input to Sarah Breeden, Fabrizio Cadamagnani, Alan Castle, Ambrogio Cesa-Bianchi, Italo Colantone, Lucio D’Aguanno, Josh De Lyon, Gerry Gunner, Emma Hatwell, Enrico Longoni, Josh Martin, Waris Panjwani, Martin Seneca and Nicolo Tamberi.