Watch inflation, trade and the Federal Reserve

By Samy Chaar, Chief Economist

In a nutshell

• The issue for 2018 is to what extent monetary tightening and trade protectionism offset the fiscal stimulus.
• We take Trump’s words at the World Economic Forum seriously and literally: “America first” does not mean America alone.
• There is no reason for the Federal Reserve (Fed) to change its pace of quarterly interest rates hikes.

"When the Democrats are in power, Republicans appear to be the conservative party. But when Republicans are in power, it seems there is no conservative party".

US Senator Rand Paul's words speak eloquently of the two-year budget deal reached mid-February, made of spending increases and tax breaks – beyond those already legislated late 2017. While positive for nominal growth, this stimulus is of course negative for the deficit outlook (widening it by 1-1.5% over the next two years), leaving the government with less fiscal room to manoeuvre when the economy turns down.

All ingredients are thus in place for inflation in the US this year: a tight labour market, translating into faster wage growth (especially in manufacturing), the traditional lag between GDP growth and inflation, and pro-growth policies being implemented so late in the cycle. Private consumption could be one area of disappointment, with the personal savings rate now close to historical lows (see chart IV, page 5) and consumers having exploited credit card debt to spend well above their income growth. All told, we foresee 2.5% US real GDP growth in 2018, slightly below the upward-adjusted consensus of 2.7%.

On the trade front, we do not expect the announced punitive measures on China to escalate into a full-blown trade war. Chinese leaders know that their trade exposure to the US is larger than reverse flows, and could eventually offer some concessions to President Trump, for him to tout as “wins" ahead of the US mid-term elections. Expanding imports from China have admittedly hurt US manufacturing employment (see chart V, page 5), but odds are that even without China the US manufacturing base would have suffered from international competition.

Turning to the Fed, the prospect of higher inflation – with the core personal consumption expenditure deflator to approach 2% – has led us to revise our expectations of the number of rate hikes this year from 2-3 to 3-4, a once-per-quarter move being our base case. An seemingly more hawkish monetary decision committee played a part in this revised outlook, although we actually view new Fed Chair Powell as being presently bullish on the US economy but not necessarily hawkish by nature.

We would caution that this base case of a once-per-quarter hike is highly dependent on all continuing to proceed well in the real economy. There is also a big difference between following the upward move in the neutral rate and hiking with a view to slowing down the economy. The Fed may not be as friendly as it was, but it has certainly not – yet – adopted an aggressive stance.