The Fed thinks it is 1995 all over again
As the financial markets worry about a broadening of US tariffs on imported goods from China and possibly Mexico, the Federal Reserve is debating the appropriate policy response to the developing trade shock.
The key question is whether it will view the shock mainly as a contraction in demand, or as an adverse supply shock (akin to the 1973 oil shock), which could raise consumer prices by a full percentage point. It is coming round to the view that it can ignore the inflationary risks from higher tariffs and cut policy rates as an insurance against rising recession risks. This is similar to what it did in 1995.
The markets emphatically see the trade war as a global demand shock that will reduce output growth without raising inflation. The policy response is unambiguous. Interest rates should be reduced, perhaps pre-emptively, in order to mitigate a future slowdown in growth. This is why the front end of the US bond market now prices in a reduction in policy rates in July, and an overall cut of 100 basis points before the end of 2020.
Until very recently, the Federal Open Market Committee had given no indication that an early cut was part of its thinking. In fact, the median dot in its March rate projections showed an increase of 25bp next year.
Even in May, the committee offered no bias about the direction of its next move and emphasised that it would be “patient” before changing its view.
When a similar gap emerged in December 2018, global equity markets collapsed amid fears that the central bank would persist in raising rates for too long. This time, in the face of an even larger trade shock, markets have been protected by a much quicker, and more dovish, response from the Fed.
In recent days, the Fed’s leadership has clearly dropped its previous neutral policy guidance. Jay Powell, chair of the Federal Reserve, has indicated that . . .
“We will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 per cent objective.”
That has generally been seen as a pledge to act swiftly if the momentum of the economy slows further.
More importantly, Fed vice-chair Richard Clarida explained in a must-read CNBC interview that he “as one member of the committee” would tend to look through the initial effects of higher tariffs on the price level, while seeking to ensure that the economy continued to grow at or near trend.
This clearly suggests that any slowdown in the growth rate, which is already slightly below trend, will trigger a policy easing, even if tariffs are pushing 12-month consumer price increases upwards at the time.
Mr Clarida went further when he pointed out that policy had been eased in the past (he specifically mentioned 1988 and, significantly, 1995) in order to provide an insurance against downside risks to activity. He added that the need for a pre-emptive easing this year would be assessed as new evidence presents itself.
It is interesting that the vice-chair, an accomplished economist who is increasingly vocal as a policy spokesman, seems ready to ignore the possible inflationary effects of the president’s programme of tariff increases. These effects were initially expected to be small and manageable, but recently estimates have increased substantially.
This is for two reasons:
- First, academic evidence has indicated that the initial set of tariffs on Chinese imports has had a larger than expected effect on US consumer prices, with little of the impact being absorbed by Chinese exporters or US wholesalers and retailers. Estimates published by the New York Fed suggest that the latest round of these tariffs will cost each American household $831 per annum in higher prices and the deadweight costs of distorted trade flows.
- Second, future tariffs may be much higher, and wider in scope, than previously feared. Goldman Sachs economists have estimated that the full effect of all the president’s threatened tariff increases, including the recently postponed Mexican tariffs, would increase the annual inflation rate by 0.9 per cent by year end. Other market estimates are even higher.
In his CNBC interview, Mr Clarida admitted that higher tariffs could act as an adverse supply shock, causing lower productivity and one-time increases in consumer prices. However, he is ready to ignore these risks because he believes that the supply side of the economy has, for other reasons, been moving in the right direction.
In a speech on May 30, Mr Clarida pointed to faster productivity growth and rising labour force participation as supply side improvements that are holding inflation down. He also believes inflation expectations are very well anchored. He is therefore willing to tolerate an adverse supply shock from tariffs without worrying about medium-term inflationary dangers.
There is little doubt that the doves on the FOMC, including Mr Clarida and Charles Evans, are moving towards a 1995-style “insurance” cut in policy rates. Then, the Greenspan Fed cut rates by 75bp over an eight-month period, arguing that these cuts were justified by success in bringing inflation under control, at a time when downside risks to economic activity appeared to be on the increase. An economic soft landing followed.
Mr Powell is likely to reflect this thinking in his press conference after the next policy meeting on June 19. The committee will probably not implement a rate cut on that date, because of its earlier promise to be “patient”. But it might use the interest rate “dot” plot to foreshadow one or more rate cuts before year end.
In the absence of outright recession, this action would remove much of the downside risk facing the equity market. In fact, bulls will point out that the equity market surged 14 per cent in the six months that followed Alan Greenspan’s first “insurance” cut in 1995.