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As financial markets worry about US tariffs on products imported from China and possibly Mexico, the Federal Reserve discusses the appropriate policy response to the growing trade shock. .
The key question is whether it will view the shock primarily as a contraction in demand or as an adverse supply shock (similar to the 1973 oil shock), which could drive up consumer prices. A full percentage point. It is coming to the conclusion that he can ignore the inflationary risks badociated with higher tariffs and reduce policy rates as a guarantee against the growing risks of a recession. It looks like what he did in 1995.
Markets categorically view the trade war as a global demand shock that will reduce output growth without increasing inflation. The political answer is unambiguous. Interest rates should be reduced, perhaps preemptively, to mitigate a future slowdown in growth. This is why the US bond market now includes a cut in key rates in July and an overall reduction of 100 basis points before the end of 2020.
Until recently, the Federal Open Market Committee had given no indication that an early reduction was part of its reflections. In fact, the midpoint in its March rate forecast indicated an increase of 25 basis points next year.
Even in May, the committee was not biased on the direction of its next move and said it would be "patient" before changing its mind.
When a similar gap appeared in December 2018, global stock markets collapsed as the central bank feared rates would persist to raise rates for too long. This time, faced with an even bigger trade shock, the markets have been protected by a much quicker and more accommodating response from the Fed.
In recent days, the Fed's management has clearly abandoned its previous neutral orientations. Jay Powell, chairman of the Federal Reserve, said this. . .
"We will act appropriately to support the expansion, with a solid job market and inflation close to our goal of 2% symmetrical."
Jay Powell
This was generally seen as a promise of quick action if the economic momentum slowed further.
More importantly, Fed Vice President Richard Clarida explained in an interview to read absolutely about CNBC that he "would tend, as a member of the committee, to consider the initial effects of rising pricing on the price level, while ensuring that the economy has continued to grow at a pace close to the trend.
This clearly indicates that any slowing of the growth rate, which is already slightly below trend, will trigger a relaxation of the policy, even if tariffs push up consumer prices over 12 months.
Mr. Clarida went further by pointing out that the policy had been relaxed in the past (he specifically mentioned 1988 and, significantly, 1995) in order to provide insurance against the risk of downsizing. He added that the need for a preventive easing this year would be evaluated as new evidence would come.
It is interesting to note that the Vice President, an accomplished economist and more and more political spokesperson, seems ready to ignore the possible inflationary effects of the President's rate increase program. These effects were initially expected to be small and manageable, but recent estimates have increased significantly.
This is for two reasons:
- First, theoretical evidence has shown that the initial set of tariffs on imports from China had a larger than expected effect on consumer prices in the United States, the impact being largely absorbed by Chinese exporters or US wholesalers and retailers. The estimates released by the New York Fed suggest that the latest round of these tariffs will cost each US household $ 831 a year in higher prices and the unparalleled costs of distorting trade flows.
- Second, future tariffs could be much higher and larger than previously feared. Goldman Sachs economists have estimated that the full effect of all of the President's threatened tariff increases, including the recently-deferred Mexican tariffs, would raise the annual inflation rate by 0.9% by the end of the year . Other market estimates are even higher.
In his interview with CNBC, Mr. Clarida admitted that higher rates could constitute an unfavorable supply shock, leading to a drop in productivity and a one-time rise in consumer prices. However, he is willing to ignore these risks because he thinks that the supply side of the economy has, for other reasons, moved in the right direction.
In a speech on May 30, Mr. Clarida pointed out that accelerating productivity growth and increasing labor market participation were supply side improvements. slow down inflation. He also believes that inflation expectations are very well anchored. He is therefore willing to tolerate an unfavorable pricing shock without worrying about the dangers of inflation in the medium term.
There is little doubt that the FOMC doves, including Mr. Clarida and Charles Evans, are pointing to a reduction in the key rates of "insurance" of 1995. Then Fed Greenspan lowered rates of 75 basis points over an eight-month period, arguing that these reductions were justified by the success of controlling inflation, while the risks to economic activity seemed to be increasing. An economic soft landing followed.
Mr Powell will probably reflect this idea at his press conference at the end of the next political meeting on 19 June. The committee is not likely to implement a rate reduction on that date because of its previous "patient" promise. But he could use the "interest rate" chart to prefigure one or more rate cuts before the end of the year.
In the absence of a total recession, this action would eliminate much of the risk of loss that the stock market is facing. In fact, the bulls will point out that the stock market jumped 14% in the six months following Alan Greenspan's first cut in "insurance" in 1995.
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