Viewpoint
March 14, 2025 | 14:15
March 14, 2025
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Consumers and Investors Fall into a Funk |
| The worst of the tariff policies hasn’t even landed yet, but their economic and financial impacts are already being factored in by investors and consumers alike. The S&P 500 and Nasdaq officially fell into contraction territory on Thursday. Yet, according to some S&P 500 P/E measures, like Robert Shiller’s Cyclically Adjusted P/E Ratio (CAPE ratio), there could still be some downside to go in the equity market. In general, the higher the P/E ratio, the more expensive stocks are compared to earnings. On March 13, the CAPE ratio was at 34.47, just below the dotcom bubble peak of 44.19 and the pandemic peak of 38.58—but still above the 32.54 peak prior to the 1929 stock market crash that helped precipitate the Great Depression (Chart 1). To get some more perspective on how expensive stocks still appear today, the long-run average CAPE ratio on the S&P 500, going all the way back to 1883, is just 17.6—almost half the current level. |
| Overall financial conditions have already tightened significantly, adding to the drag on the economy. The Bloomberg Financial Conditions index is back into tightening territory, a rare occurrence over the past year and a half, while stock market capitalization has already declined by around $6.8 trillion since the February 19 peak (Chart 2). A robust positive wealth effect was a big part of 2024 consumer spending resilience; now, as it goes into reverse, it takes away an important pillar of consumer spending strength. Consumers are also feeling unsettled and re-evaluating what these new economic policies might mean for future inflation, job prospects, and their ability to make debt payments. The responses from the February New York Fed Survey of Consumer Expectations were very telling. Consumers are already ramping up their one-year ahead inflation expectations on a number of major expense categories (Chart 3). For example, they expect medical care prices to increase 7.2%; college education prices to increase 6.9%; rent to increase 6.7%; and food prices to increase 5.1% in the year ahead. Inflation expectations for these categories haven’t been this high in nearly a year. At the same time, their view of labor market resilience is deteriorating. The average probability of finding a job in the next three months, if they lost it today, slipped to 51.2% in February (Chart 4). This is among the lowest readings on this measure since 2021. The most telling response illustrating the increasingly precarious financial position of many households today is the spike in the average perceived probability of missing a minimum debt payment over the next three months. That probability increased to 14.6% in February, its highest since April 2020 (Chart 5). On the bright side, an unexpected truce or end to this trade war could quickly ease consumers’ and investors’ current funk, leading to a sharp rebound in sentiment and equity market valuations. However, should the trade war linger or worsen in the months ahead, as we suspect it will, the current funk could soon metastasize and have longer lasting effects on economic activity and the labor market. |
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FOMC Preview: Flying in Policy Fog |
| This week marks the fifth anniversary of the WHO’s declaration of the COVID-19 pandemic. And it was only during the immediate months after the onset that uncertainty surrounding U.S. economic policy prospects was higher than it is today. The Economic Policy Uncertainty Index, courtesy of the folks at Stanford University and the University of Chicago, is currently at the highest level in its 40-year history apart from seven months in 2020. The cloud this casts over economic prospects has not been lost on financial markets. For example, the S&P 500 is down around 8.5% (as of mid-Friday) from its post-election peak (February 19). It’s amid this uncertainty that the Fed is having to craft monetary policy. In a March 7 speech, Chair Powell said: “The new Administration is in the process of implementing significant policy changes… It is the net effect of these policy changes that will matter for the economy and for the path of monetary policy.” He added: “Uncertainty around the changes and their likely effects remains high… We do not need to be in a hurry, and are well positioned to wait for greater clarity.” We reckon such comments are going to be a theme running through Powell’s responses in the press conference following the policy announcement on March 19. The FOMC is expected to keep the target range for the fed funds rate at 4.25%-to-4.50% for the second consecutive meeting. Market participants will be searching the policy statement, Summary of Economic Projection (SEP) and its ‘dot plot’, along with the presser, for clues to the timing of the Fed’s next actions. In the policy statement, we look for the economic assessment to be slightly toned down from “continued to expand at a solid pace”, with the latest drop in real PCE and jump in imports weighing. We reckon the remainder of the statement could be repeated verbatim. The old dot plot’s median projection had 50 bps worth of rate reductions this year, a forecast shared by 10 of 19 participants. It would take at least half of them adding an extra quarter point cut to turn the median dial, which we suspect could be a tall order. Any shift in aggregate sentiment towards more rate cuts should instead be reflected in a lower mean forecast (3.836% previously). The old SEP also had 50 bps of easing next year and 25 bps in 2027 (to 3.125%), and we’re not bracing for much change. We’re expecting changes to the other median forecasts, particularly for this year. The previous projections (for Q4) were 2.1% y/y for real GDP growth, 4.3% for the unemployment rate and 2.5% y/y for both total and core PCE inflation. Compared to three months ago, more participants’ individual projections are probably incorporating some measure of the growth-diminishing, inflation-augmenting impacts of tariffs. We reckon the new forecasts will show slower growth (under 2% y/y), higher joblessness (by at least a tenth), and faster inflation (but still staying under 3%), before restarting trends to their longer-run levels. In the presser, apart from the theme mentioned above, we look for Powell to keep his policy cards close to his chest. This reflects both the lurking extreme degree of uncertainty and the looming major tariff announcements due next month. For the record, the market is currently pricing in about 65 bps in rate cuts by year-end, with the first move nearly fully priced in by June. |
Has the Fed Misjudged Inflation?Inflation was on a slow path back to the 2% target before tariffs but now faces a material roadblock. |
| Taming inflation has proven to be more challenging than expected. While policymakers initially made good progress, getting back to the 2% target remains elusive. Even before tariffs became a real threat, many analysts wondered if the Fed would reach its goal without maintaining a moderately restrictive policy stance for some time. Here are four things to know to help assess where inflation is headed. 1) The current underlying trend is meaningfully above the 2% target. An examination of six ‘core’ measures of inflation (Table 1) suggests the underlying rate is (1) hovering about one percentage point above the target, or three-fourths based solely on core personal consumption expenditure prices (the Fed’s preferred measure), and (2) making glacial progress toward the target.
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| Inflation was sticky even before January, when businesses likely front-loaded some price increases at the start of the year. This stickiness was confined to the services sector (Table 2). The good news is that services inflation is edging lower, even apart from rent increases that look to moderate further amid falling new lease rates (Chart 1). The bad news is that goods deflation is also starting to turn. Moreover, this trend could continue given some recent firming in producer prices and an increase in prices paid for materials in the ISM manufacturing survey. As discussed later, the upturn in goods prices could reflect businesses raising prices in anticipation of tariffs. 2) Inflation expectations are moving the wrong way. |
Both the University of Michigan (Chart 2) and Conference Board surveys show recent sharp spikes in households’ inflation expectations. In fact, the former saw five-year-ahead expectations jump to 32-year highs in March, likely reflecting fears of a prolonged trade war. The New York Fed Survey of Consumer Expectations also shows some deterioration. However, inflation expectations derived from Treasury inflation-protected securities do not. The main takeaway is that inflation expectations likely have risen somewhat. Should they feed into wage-setting and pricing behaviour, the Fed will have a greater challenge on its hands. 3) Powell is right, labour market conditions are likely not a source of price pressure. After grinding higher, the unemployment rate has leveled off at 4.1%—a tick below the median FOMC forecaster’s estimate of neutral. Based on job openings and reported job prospects from the Conference Board consumer survey, labour market conditions remain healthy. Nonfarm payroll gains, though moderating, remain decent at 1.2% y/y in February. However, labour market conditions have loosened. Layoff announcements spiked in February, even outside the federal government. The so-called ‘underemployment’ rate, which accounts for marginally attached and involuntary part-time workers, spiked to a three-year high of 8.0%. As a result, wage increases are slowing. That, combined with decent productivity gains (2.0% y/y), has cooled unit labour costs to a rate (2.0%) aligned with price stability (Chart 3). With tens of thousands of federal agency positions at risk and tariffs expected to slow the economy, the jobless rate could rise to 4.5% at year-end, applying further downward pressure on inflation. |
| 4) Tariffs will initially raise inflation. With consumers likely to bear a good portion of the tariffs, the main question is how high will inflation go and for how long? Without clarity on future trade policies, no one can be sure. But for now, we estimate that if the 25% tariffs on Mexico and Canada (10% on Canadian energy resources) take full effect on April 2, they, along with the 20% duties already applied to China, could raise core PCE inflation by 0.7 percentage points—from 2.6% y/y in January to 3.3% by year-end. Recent surveys suggest some businesses aren’t waiting for tariffs to affect costs before raising prices. Still, should labour market conditions loosen further, as we expect, core inflation will likely return to current levels by mid-2026, before falling further toward the target. Policymakers will need to trust that the initial spike in inflation is transitory (even if they never use that term again after the 2021 trauma). If so, we believe the Fed will resume easing policy in September and reduce rates by a total of 125 basis points thereafter. Bottom Line: Though still materially above target, inflation is edging lower. Services inflation—an earlier source of stickiness—is easing, even apart from moderating rents. While new tariffs will push goods prices higher, they will also slow the economy somewhat, which should corral inflation back to current levels by early next year. Nonetheless, the Fed faces a delicate balancing act—navigating higher inflation on one side and slower growth on the other—to find the right policy mix to achieve its dual mandate. Crosswinds from uncertain trade policies risk a serious misstep on this tightrope. |
