The Great Economic Experiment

When my kids were little and we took them out for fast food, my littlest one loved using the self-serve soda machine. It was his opportunity to play mad scientist, filling his cup with a mix of different soda options. This young ‘mixologist’ had no fear of combining together such different drinks as grape soda, lemonade, cola, root beer and diet cola – really, whatever was on offer. While others watched in horror (and no doubt sat in judgment that I was a bad mother), my youngest boldly filled his cup to overflow and then challenged us to taste each mad concoction. Every now and then, I must admit, it actually turned out well – or at least ok – although most of the time, it was downright disgusting. But we never stopped our little mad scientist from doing this – we thought he might have an aptitude for science and fulfill my dream of having a doctor (or cancer researcher) in the family. And besides, it was a harmless experiment.

We are currently watching another experiment underway, but it’s far riskier. We are seeing what happens to an economy when you apply high tariffs to imported goods at the same time as implementing a strictly enforced immigration policy and cutting government spending in areas with higher multiplier effects. This is an unusual policy combination – one which could result in a recession, possibly stagflation. However, like my son’s mystery concoction, we won’t know in advance how it will turn out.

Inflation surprise

We got some clues on how it might turn out from last week’s personal consumption expenditure (PCE) report and the July jobs report. Core inflation, the Fed’s preferred measure of inflation, was higher than expected; the core PCE index for June was up 0.3% month-on-month and 2.8% year-on-year. In addition, May core PCE was revised up to 2.8% year-on-year as well. And the July jobs report was also disappointing, with significantly lower nonfarm payrolls created than expected – and, more importantly, serious downward revisions to the last several months. While this is not enough evidence to declare that current policies are very negative for the US economy, it is enough to make me worry and watch carefully for other signs of the effects of this unique policy combination.

But rather than change course on policies, the approach appears to be to fire the head of the US Bureau of Labor Statistics (BLS). There have already been worries about the quality of the data in the face of significant government cuts to this agency, but now markets will have a compelling reason to distrust the data. There are other countries whose economic data has not been trusted by global investors, who have felt the need to resort to tactics such as tracking electricity usage to get a sense of the strength of a country’s economy. It feels like we are headed in that direction. I think it’s important to note that this is the first time a US president has fired the head of the BLS. In my opinion, this is serious and increases the country risk premium for investing in the US.

I must admit, from a practical standpoint, I don’t understand why the BLS head was fired if the White House wants the Fed to lower rates. This last jobs report, with its downward revisions to payrolls over the last several months, makes the best case yet for the Fed to be worried about economic growth and actually cut rates. Fed Chair Jay Powell was very clear at the Federal Open Market Committee (FOMC) press conference last week that he thinks the labor market is healthy and that his focus is on inflation because inflation has not yet reached the Fed’s target. That’s why Powell sounded hawkish when asked about the potential for inflation from tariffs:

“This will not turn out to be inflation because we’ll make sure that it’s not. We will, through our tools, make sure that this does not move from being a one-time price increase to serious inflation.”

The two dissenting FOMC members did so because they believe there is underlying weakness in the US economy, particularly the job market. The best case for cutting rates this year would be a significant deterioration in the labor market – which Friday’s data release may be signaling. As Fed Governor Chris Waller warned,

“When labor markets turn, they often turn fast.”

This would change the balance of risks and likely force the Fed to act.

Recipes from around the globe

The Bank of England (BoE) is in a similar position to the US in that it is juggling the same two considerations. I expect the BoE to cut this week as declining growth is likely to be considered the more urgent issue. Having said that, CPI inflation for April appears poised to increase materially in the near term. Not an enviable position for a central bank to be in as worries about possible stagflation continue to increase. However, I think the immediate threat is declining economic growth, so that is what the Bank of England will respond to.

It’s worth pointing out there are different policy ‘mixologists’ in other parts of the world. For example, in China it’s all about fiscal stimulus. The Party Politburo recently met; at the conclusion of multi-day meetings, it issued a statement encouraging continued policy support...

“Macro policies must continue to exert strength and be stepped up when appropriate” 

...so that China can effectuate stronger domestic demand. Stimulus will need to be strong in the face of significant US tariffs, and I’m optimistic it will be an adequate countervailing force to tariffs.

Ditto for Europe. The European economy is showing signs of improvement, likely helped by increased stimulus in the offing. The eurozone manufacturing PMI for July reached 49.8; while this is still in contraction, it is a 36-month high. More good news is that the US and European Union just agreed to a trade deal framework that applies 15% tariffs to most European goods being purchased in the US, which reduces uncertainty. The bad news is that this is a huge increase over current tariff levels. However, I think European economies’ planned increases to defense and infrastructure spending – especially Germany’s – should be a powerful countervailing force to the damage that US tariffs can do to the European economy.  

The Bank of Japan decided last week to take a ‘wait and see’ approach to the impact of US tariffs on its economy and hit the ‘pause button’ on rate hikes. This was an especially wise decision given recent worries about rising borrowing costs with more fiscal stimulus in the offing. I do think Japan needs more fiscal stimulus in the face of high US tariffs, but I also think it could trigger bond vigilantism because of rising debt levels. Therefore, keeping rates on hold was a prudent decision as it assesses the impact of its policy mix.

A toxic cocktail? 

In summary, just like we won’t know what any given policy mix will bring to an economy – especially an unorthodox or unusual policy mix – we can make educated guesses, and adjust as we learn more from new data. We also don’t know how markets will react as the data is released and paints a clearer picture of the impact of policy mixes (although we got a preview on Friday, as US stocks sold off and Treasury yields fell). All we can do is hope that the ‘mixologists’ making policy decisions in various economies are willing to pay attention to the data and adjust their policies as needed.

The Week Ahead

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