Viewpoint
November 22, 2024 | 14:41
November 22, 2024
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Fed Policy: No, Virginia, There Isn’t a Santa Pause*(*As far as we can fathom at this point.) |
| The money market is currently pricing in near-even odds of a quarter point paring of policy rates by the FOMC on December 18. In other words, it’s a coin flip whether the Fed takes a pass. For a rate-cut campaign that began only two months ago with a surprise 50 bp action, such a sudden intermission can’t be ruled out. But we reckon the rate-cut odds are much higher and still forecast a 25 bp reduction in less than four weeks (unless something untoward unfolds on the data front). In the wake of the surprise September move, the market was pricing in more than 75 bps worth of cuts over the final two meetings of 2024. But after the strong September employment report, market expectations had been reined in to just under 50 bps worth of cuts over the next two confabs. The ‘pause odds’ have been mounting ever since. There are three pieces to the market’s pause puzzle, but we judge they still don’t fit together adequately (hence our continued rate cut call… for now). First, inflation is proving to be too stubborn. For (at least) the past two months, the core and ‘supercore’ inflation readings have been raining (at least) 0.3%s on both the CPI and PCEPI fronts (the latter’s will likely be revealed on November 27). This is a cause for concern. But when the Fed declared back in September that it had “gained greater confidence that inflation is moving sustainably toward 2 percent”, this was not the sort of confidence that would be easily shattered. That said, another month or two of similarly stubborn results could indeed crush confidence, particularly if next year begins as this year did with a flash of annual price hikes from a wide assortment of businesses. Unless November’s CPI (due December 11) is profoundly disappointing, we doubt what’s happening on the inflation front is enough to elicit a pause next month. |
| Second, in the wake of the election’s outcome (a Republican trifecta victory), fiscal and trade policies could soon be taking net growth-boosting and inflation-fueling turns. If they do, the Fed’s risk management approach would likely lead to policy adjustments. But legislatively, such comprehensive turns do take time. And, in the meantime, the Fed will be conducting monetary policy based on “the implications of incoming information for the economic outlook”. Such information includes “readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments”. It doesn’t include how potential future fiscal and trade policy changes could impact the outlook. That said, to the extent the market begins to ‘permanently’ price in such potential changes, there could still be some influence on Fed policy via financial conditions. But we’re not there yet. |
Third, economic growth is proving too resilient. The market’s proof points would include real GDP expanding at a solid 2.8% a.r. in Q3 or 2.7% y/y. It would also include recent job market readings, looking past the negative impact the hurricanes and strikes had on October’s numbers. But this is where we disagree the most with the market. We judge the Fed is perfectly fine with a strong economy and labor market if they have muted inflationary influences. The Fed no longer worries as much as before about the ‘potential’ inflationary consequences of sturdy growth and tight labor markets. Indeed, in the latest post-FOMC presser, Chair Powell re-asserted that “the labor market is not a source of significant inflationary pressures”. Previously, Powell had proclaimed: “We do not seek or welcome further cooling in labor market conditions.” Simply put, until inflation’s results and risks convince otherwise, we reckon the Fed is very keen to prevent the unemployment rate from trending above the FOMC’s longer-run level and job growth from trending below zero (Chart 1). So, the next employment (due December 6) and CPI reports are critical for the Fed. The takeaway is that what’s on the ground, in our view, is not yet the stuff of a Fed pause. |
Tariffs: Round 2Trade protectionism likely won’t knock out the U.S. economy but could buckle its knees. |
| Donald Trump’s return to the White House has world leaders anxious about another trade tussle that could make his first round six years ago look like a sparring match. The latest threats (subject to change) include a 10%-to-20% across-the-board tariff increase for all countries and hikes of at least 25% for Mexico and 60% for China. Trump has even talked about doubling and tripling tariffs if he doesn’t get his way. By one estimate (Evercore ISI), the average tariff on U.S. imports could leap from less than 3% today to 17%, which would be the highest since the Depression. Before delving into the potential consequences for the economy, it’s worth understanding what a tariff is. It’s a tax on imports. Like other taxes, it transfers money from consumers and businesses to the government. Tariffs are paid by the importer (usually businesses), remitted to the government, and often transferred to consumers via higher prices. Like most taxes, it can yield both benefits (more revenue for governments to deliver services or reduce other taxes) and drawbacks (less money for consumers and businesses to spend and invest; misallocation of resources). Unlike taxes, however, the President has near-unilateral power to impose tariffs. Although the Constitution grants Congress control over trade, the executive office can override this power if it deems that a country has an unfair trade advantage or its products pose a national security risk. Imposing a blanket tariff on all nations, however, might run into judicial resistance. Apart from raising revenue and changing a country’s behavior, the main reason for increasing tariffs is to discourage consumers and firms from buying foreign products, thereby protecting domestic manufacturing industries and supporting jobs. But most economists believe tariffs are a poor tool for accomplishing these goals. A tariff may not reduce the trade deficit if it leads to a stronger currency, retaliatory actions, and a loss of competitiveness, all of which weaken exports. Simply put, tariffs usually cause more harm than good. That harm starts (but doesn’t end) with inflation. By raising the cost of imported goods, tariffs are inflationary. To what degree, however, depends on several things. Given an 11% share of GDP and estimated similar share for consumer spending, a 10% tariff on all U.S. goods imports could directly raise prices by 1.1%. The tariff would lead to some decline in imports, though likely a small one as domestic producers (already operating near capacity) wouldn’t be able to replace most imported goods. Lower imports, in turn, would cause the dollar to appreciate due to less buying of foreign currencies by domestic firms (or less selling of dollars by foreign firms selling goods, such as oil, denominated in greenbacks). A 5% appreciation, for example, would chop the import price increase further to around 0.5%. (In fact, the dollar has already surged 6% in the past two months partly due to the mere threat of tariffs.) Furthermore, foreign producers could cut prices to protect sales; a 2% reduction, for example, would further shave the increase in import prices to 0.3%. Finally, U.S. retailers might absorb a portion of the tariff increase by trimming costs or shrinking profit margins. These dampening forces, however, could be partly offset by domestic producers raising prices to cover the higher cost of supplies or tariff-protected industries raising prices. The upshot is that inflation would likely rise, though potentially much less than suggested by the tariff. The Peterson Institute for International Economics believes a 10% tariff hike could boost U.S. inflation by 0.6 ppts points in 2025. Of course, the larger the increase in tariffs, the bigger the increase in inflation. |
| Trump’s first round of tariff increases in 2018-19 likely had minimal effect on inflation when looking at import and producer prices (Chart 1). This is because the average tariff on imports rose only modestly (by less than a percentage point, as the increases were largely targeted at China and covered a small fraction of U.S. imports) and the trade-weighted dollar appreciated (by 5% in 2018-19). Still, prices did rise sharply on some items, such as washing machines. The reason a country trades is to get access to a wider variety of goods at lower cost than could be produced domestically. Tariffs throw a wrench into this process. Higher inflation drains purchasing power, especially for lower income earners who spend a large share of their income on consumer goods. It also pushes up interest rates. Retaliatory tariffs, currency appreciation, and reduced competitiveness due to higher-costing supplies constrain exports. Supply disruptions weaken business investment and reduce productivity. The government could try to limit the damage by using the tariff revenue to cut taxes or boost spending, but this risks fueling even more inflation. |
Several recent studies have estimated the economic impact of Trump’s proposed tariffs. The IMF finds a 10% across-the-board tariff, matched by other countries, could reduce U.S. real GDP by 1.0% through 2026, while the Tax Foundation sees a slightly larger 1.1% hit and the Peterson Institute a slightly smaller 0.9% effect. Of course, the much larger increases proposed for China and Mexico would only magnify the impact. For comparison, the Congressional Budget Office estimated that the 2018-19 tariff increases reduced U.S. GDP by 0.3% after two years. As some consolation, it’s unlikely that every country would counterpunch with a tariff on U.S. goods, especially if their currency weakened and mitigated the impact. Still, the key point is that tariffs are stagflationary—bad for both growth and inflation. Bottom Line: We will await details on the timing and scope of Donald Trump’s protectionist agenda, and on the counter responses of trading partners, before revising our outlook for inflation and the economy. It’s safe to say that neither change would be for the better. Hopefully, the tariff threats are mostly a bargaining tool, and won’t fully translate into policy action. |