LONDON (Reuters) - A collapse of U.S.-China trade talks and hike in tariffs on Chinese goods would push the world economy towards recession and see the Federal Reserve cut U.S. interest rates back to zero within a year, analysts at Morgan Stanley said on Monday.

FILE PHOTO: A sign is displayed on the Morgan Stanley building in New York U.S., July 16, 2018. REUTERS/Lucas Jackson/File Photo

While a temporary escalation of trade tensions could be navigated without much damage at all, a lasting breakdown would inflict serious pain.

“If talks stall, no deal is agreed upon and the U.S. imposes 25% tariffs on the remaining circa $300 billion (£235 billion) of imports from China, we see the global economy heading towards recession,” the bank’s analysts said in a note.

In response, the Fed would cut rates all the way back to zero by spring 2020 while China would scale up its fiscal stimulus to 3.5% of GDP (equivalent to around $500 billion) and its broad credit growth target to 14-15% a year, they added.

“But, a reactive policy response and the usual lags of policy transmission would mean that we might not be able to avert the tightening of financial conditions and a full-blown global recession.”

A global recession is defined by growth dipping below the 2.5% a year threshold.

In a middle scenario where 25% tariffs on $200 billion of U.S. imports from China stay in place for 3-4 months, global growth could slow around 50 basis points to 2.7% a year.

They predicted the Fed would cut rates by 50 basis points to cushion the blow while Beijing would up its total fiscal expansion to 2.25% of GDP, or about $320 billion.

Morgan Stanley’s analyst also warned investors could be underestimating the impact of trade tensions in a number of ways.

Firstly, the impact on the U.S. corporate sector would be more widespread as China could put up non-tariff barriers such as restriction of purchases.

Given the global growth slowdown that would follow, profits from firms’ international operations would be hit and companies would not be able to fully pass through the tariff increases to consumers.

The indirect impact would be “non-linear” too, with a sharp tightening of financial conditions and policy uncertainty hitting firms’ confidence to the extent that they freeze or cutback on capital expenditure.

“Our base case is that the escalation is temporary, but we would readily admit that the uncertainty is high with regard to how trade talks could evolve.”

“The impact on global growth is non-linear – the risks are firmly skewed to the downside and the window for resolution is narrowing.”