Viewpoint
January 31, 2025 | 13:49
January 31, 2025
Economics
Economics
Economics
Economics
Economics
Economics
Let’s Not Rock the Boat |
| The economy is in a pretty good place right now, so let’s not rock the boat. The Q4 GDP report reveals just how good it is amid sturdy domestic demand. Already-strong real final sales to private domestic purchasers shifted into an even higher gear in the second half of 2024, increasing at an average 3.3% annualized rate (Chart 1). This measure provides a clearer picture of private domestic demand than GDP since it excludes government spending and changes in private inventories which can be volatile. |
| One of the most amazing and unexpected developments of 2024 was the resilience of consumer spending. Despite what the Fed calls ‘a restrictive monetary policy’, real consumer spending managed to accelerate for three consecutive quarters, ending the year on a strong note at a stunning 4.2% annualized growth rate. No other component has added more to GDP growth over the past year (Chart 2). It was an unlikely three consecutive quarter acceleration in durable goods outlays that led consumer spending to new heights (Chart 3). Based on this strength, we increased our Q1 real consumer spending growth forecast to 3.0% a.r. (Chart 4), adding a tenth of a percentage point to our Q1 GDP forecast, which is now at 2.3% annualized. This is very good news, but it also makes the economic expansion vulnerable to a sharper-than-expected slowdown, should consumers suddenly decide to become more cautious in their spending. President Trump’s imminent threat to impose 25% import tariffs on Canada and Mexico, two of the United States’ largest trading partners, on February 1 has the potential to become such a shock, especially if it leads to significant consumer price increases and trade retaliation for our most valuable exports. Canada and Mexico are already lining up their lists for retaliation. Even a temporary inflation shock from emerging trade wars could put more upward pressure on longer-term interest rates and keep the Fed on hold longer than currently expected. Currency markets have already shown flashes of volatility, and equity and bond markets could be next. Wall Street has largely come to the view that the tariff threats are mostly a negotiation tactic to limit immigration and increase border control, or reopen USMCA negotiations early. However, should they prove to be more entrenched and invasive, financial markets could be in for a nasty surprise that would quickly add new downside growth risks. Within weeks, we could easily be pushing our Q1 real consumer spending forecast back down to 2.5% annualized, should the worst begin to materialize. If across-the-board 25% tariffs are left in place for a year, we could see GDP growth as much as a half a percentage point lower than currently forecasted. I continue to be impressed with the strength and resilience of this economic expansion. For more than two years now, the U.S. economy has defied expectations for a sharp slowdown, mostly due to a resilient consumer and labor market. Moreover, the economy appears on track to largely repeat the performance in 2025 with only a mild deceleration in growth. But, I fear policymakers in Washington are becoming a bit too complacent with the economy’s outperformance and, by rocking the boat on tariffs and immigration, they could soon set the consumer and economy up on a far less sanguine growth path. |
The ‘America First Trade Policy’ Plan |
| President Trump signed the ‘America First Trade Policy’ memorandum on Inauguration Day. The executive action instructs several departments and agencies to review current trade policies and investigate specific trade issues and then report back to the President by April 1 with their findings and recommendations. However, it doesn’t appear the President intends to wait for his requested reports when it comes to applying tariffs on Canada and Mexico. These could be announced as early as January 31 or February 1. The sweeping trade policy agenda is divided into three key sections: (1) Addressing Unfair and Unbalanced Trade; (2) Economic and Trade Relations with the People’s Republic of China; and (3) Additional Economic Security Matters. Below, we mostly focus on the first section. Addressing Unfair and Unbalanced TradeThe President’s first directive was to: “investigate the causes of our country’s large and persistent annual trade deficits in goods, as well as the economic and national security implications and risks resulting from such deficits, and recommend appropriate measures, such as a global supplemental tariff or other policies, to remedy such deficits”. |
| The goods trade deficit was a record $1.20 trillion in 2024 (based on national accounts figures which are the most current complete data). This beat out the earlier record (year ended 2022 Q3) by a whisker (Chart 1). Part of the shortfall’s recent deterioration reflects the fact that domestic demand and GDP have grown more strongly than many of its foreign counterparts. As a share of GDP, the goods trade deficit was 4.1% in 2024, below the middle of the 3.7%-to-4.9% range in place since the period ended 2009 Q2. By this measure, the deficit is still “persistent” but not as “large” as the dollar amount portrays. Indeed, this ratio hit a record 6.4% in 2006 Q3. It appears the Great Recession was instrumental in broadly stabilizing America’s goods trade deficit, at least as a share of GDP. |
While the Administration’s focus is on goods, most of the economy produces services (more than 80% of GDP). And it sports a trade surplus in services. It was $296 billion in 2024 or 1.4% of GDP and the balance has been persistently positive for decades. Obviously, the services trade surplus pales in comparison to the goods trade deficit, but this still leaves the total trade shortfall at $910 billion in 2024 or 3.1% of GDP. The latter suggests relatively better improvement from its record high of 5.9% in 2006 Q3; it has been almost halved. |
| Nevertheless, the Administration appears bent on addressing the goods trade deficit with a universal tariff or what the memo refers to as a “global supplemental tariff”. It’s unclear whether some goods or countries would be carved out, but the fewer the exemptions, the greater is the tariff regime’s simplicity and revenue generation capability. However, some countries contribute more to the total deficit than others, and the U.S. even has a goods trade surplus with some nations. This makes a common tariff to address an aggregate trade imbalance inherently unfair. For example, China is the largest contributor to the goods trade deficit, accounting for 25.1% (Table 1). This is followed by the European Union (19.8%), Mexico (14.6%) and Vietnam (10.5%). These four jurisdictions alone, each with $100 billion-plus balances, account for 70% of the total shortfall. Meanwhile, the U.S. has a $49 billion trade surplus with the entire South-Central America region and a positive balance with other countries. Even within the EU’s hefty deficit, the U.S. has surpluses with some member nations. It tops $55 billion with the Netherlands. And Canada stands out. The deficit with its northern neighbor is about $60 billion (5.2% of the total) but, among the larger economies, bilateral trade is more balanced than in any other ‘deficit relationship’. Canada is America’s second-largest export market behind the EU, and it’s the largest when looking just at the Euro Area members. For every dollar of imports from Canada, the U.S. exports 85 cents to Canada. And accounting for massive energy imports, the U.S. has a net trade surplus with Canada too. Other directives in this section include the following:
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Economic and Trade Relations with the People’s Republic of ChinaHighlighting this section is the directive to review the trade deal between the U.S. and China, the so-called ‘Phase One Trade Agreement’, that was signed on 15 January 2020. And “to determine whether the PRC is acting in accordance with this agreement, and shall recommend appropriate actions to be taken based upon the findings of this review, up to and including the imposition of tariffs or other measures as needed”. |
| At the time, the deal was touted as addressing “certain acts, policies, and practices of China identified in the Section 301 the investigation related to technology transfer, intellectual property, and innovation”. Section 301 of the Trade Expansion Act of 1962 allows tariffs for the purpose of tackling unfair trade practices. These tariffs were announced 8 March 2018 and subsequently ramped up. The trade deal held out the hope that after a period of proven compliance, these tariffs could start being trimmed. It also included targets for increased Chinese purchases of American goods and services ($200 billion above base levels over two years). Then came COVID-19. The post-pandemic disruptions to domestic and global supply chains saw U.S. imports from China surge and the bilateral trade balance deteriorate, although the deficit has since trended down (Chart 2). China’s promised purchases of U.S. goods and services have not materialized. Compared to 2017, U.S. goods exports to China, at their peak, were up less than $30 billion per annum. |
Another highlight is the directive to assess the Biden Administration’s (14 May 2024) four-year review of Section 301 tariff actions and their consequence, and “consider potential additional tariff modifications as needed… particularly with respect to industrial supply chains and circumvention through third countries”. Additional Economic Security MattersHighlighting this section is the directive to “conduct a full economic and security review of the United States’ industrial and manufacturing base to assess whether it is necessary to initiate investigations to adjust imports that threaten the national security”. This lifts the prospects for tariffs on more goods under ‘Section 232’ of the Trade Expansion Act of 1962, like the ones applied on steel and aluminum imports in the first Trump Administration (announced 8 March 2018). Indeed, there is also a charge to “review and assess the effectiveness of the exclusions, exemptions, and other import adjustment measures on steel and aluminum”. |
| Most countries affected by the original Section 232 tariffs on steel and aluminum eventually worked out quota arrangements. Restrictions on Canada and Mexico were removed (but with monitoring provisions) as part of the negotiation of the USMCA. Although the tariffs did appear to initially dampen imports (Chart 3), the post-pandemic disruption to domestic and global supply chains saw them surge. As disruptions faded, so too did imports of steel and aluminum, but both are still above where they were at the time of the original tariffs. A final highlight is the directive to “assess the unlawful migration and fentanyl flows from Canada, Mexico, the PRC, and any other relevant jurisdictions and recommend appropriate trade and national security measures to resolve that emergency”. As mentioned at the beginning, the President appears unlikely to wait for the report’s results before announcing tariffs tied to this issue. |
Bottom Line: President Trump once referred to himself as “Tariff Man”. He appears poised to live up to that moniker again. |