The Risk of Trade Wars
The Trump Administration is resetting U.S. trade policies, much to the consternation of our key trading partners. Some economists fear a return to the “beggar thy neighbor” trade policies adopted during the Great Depression, which are thought to have deepened and extended the Great Depression. A Reuters survey this spring showed that 80% of 104 economists believe that steel and aluminum tariffs would harm the U.S. economy. However, the U.S. economy is currently strong and the drag from trade disruption is still relatively small. We do not expect trade tensions to escalate to the point where the U.S. economy is fundamentally impaired. But any move away from the global status quo will be disruptive, generating costs and benefits. Somebody's ox gets gored somewhere.
It is a very complex analysis to determine how the costs and benefits from the short-term disruptions that are occurring are weighed against medium and longer-term costs and benefits. The costs and benefits are themselves complex. Some can be measured in economic terms on specific industries and companies and may have geographic components. Some can be measured in terms of national welfare. Some are strategic, including those related to national defense, and some are purely political.
Downside effects that are already happening are: higher prices for some imports, reduced demand for some exports, increased uncertainty, businesses reducing leverage, delayed investment, lots of planning for alternative supply chain strategies, inventory management and uncertain pricing strategy. Some businesses may already be delaying hiring. However, overall labor market indicators, including the recent June jobs report from the BLS, remain strong.
In our view, it is beyond the capabilities of economic analysis to develop a conclusive cost-benefit analysis of the current trade policy changes, accounting for both short-term and long-term effects. Simplified assumptions may be fed into macroeconomics models, but the results of simulations will be shaped by the assumptions themselves and by the inherent biases of the models. The Great Recession taught us that much of economics is nonlinear, meaning that relationships between variables and actors change over time. Complex events with nonlinear interactions are inherently unpredictable. However, we should heed the guidance that economics can provide. Economic theory tells us that free and fair trade is efficient and improves the welfare of the trading countries. However, it does not tell us the best route to get to free and fair trade from where we are now.
In the near-term, a significant trade war would result in higher import prices and reduced demand for U.S exports. This could put the Federal Reserve in a dilemma if the U.S. economy faced higher inflation as uncertainty and business stress increases. It resonates with the stagflation scenario that some economists, including Alan Greenspan, fear. In this scenario, the Federal Reserve could feel the need to raise interest rates to fight inflation when economic growth is cooling, just as the positive effects of the tax reform wind down. A measured, proportionate and agile approach to trade policy could help to mitigate against potential adverse consequences.
We expect to see Q2 real GDP growth in the neighborhood of 4.0 percent. This may be the strongest GDP growth this year. Productivity growth has been historically weak, but it may jump in Q2, to about 3 percent. Stronger productivity growth is essential in order to keep the now 108-month-long expansion going. Stronger productivity growth would also mean that wage growth, due to very low unemployment, would not necessarily be inflationary. This could give the Federal Reserve extra maneuvering room in setting interest rates in 2019.
For a PDF version of this report, please click here: July 2018 US Economic Outlook
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