When it comes to the U.S. economy, there is no shortage of things to worry about: Trade tensions have been rising; exports have been weakening; manufacturing has been weakening; corporate profits have been weakening; and the yield curve is sending what has historically been a recession signal.
Based on that assessment, it wouldn’t be hard to extrapolate and look for a recession before long. Yet HFE’s Chief Economist Jim O’Sullivan is not forecasting a recession any time soon. He explains why in this Q&A:
HFE is quite negative about global trade flows, using the “R” word for Europe, particularly Germany. Is there a disconnect between HFE’s U.S. and non-U.S. analysis?
Exports account for a relatively small share of GDP in the United States. Specifically, they equate to 12% of GDP, well below the 29% average for all countries. The number for Germany is 47%.
While it is unclear how much of the slowing in global trade flows has been because of fallout from the Trump administration’s trade warmongering, and how much has been due to other factors, the end result is that U.S. growth is much less affected by global trade flows than most countries. There are also precedents for growth in the United States staying reasonably solid even with exports contracting, including in 1998, the time of a previous “mid-cycle adjustment” by the Fed. It happened as recently as 2012 and 2015 as well.
Having said all that, those earlier periods were not associated with a trade war, and there is a meaningful risk that worries about trade policy will undermine business confidence broadly, not just for firms with significant export exposure.
You have 75 basis points of easing in your forecast in total—so one more 25 basis point move—in line with previous “mid-cycle adjustments.” Do you think the Fed could stop at 50 in light of the divergence of views and the no-more-easing median dot plot projection at the latest meeting?
Yes, that is certainly possible. It is also possible that the economy keeps weakening and the Fed has to ease by a lot more than 75 basis points. The point is that there is a limit to the information value of the dot plot.
That said, we did tweak our forecast a bit after the last FOMC meeting to call for the third easing to come in December rather than October. Given the projections released after that meeting, economic and market developments would probably have to be more negative than they have been recently to trigger another move as soon as October.
After one of those mid-cycle easings—1998—the Fed quickly turned around and started tightening again. Might that happen again?
One could argue, based on the data and financial conditions, that there has been much less of a case for Fed easing than there was in previous mid-cycle adjustments, notably the 1995, 1998 and 2002 episodes.
We see two big differences between this episode and those previous episodes, even if the data keep surprising on the upside. First, Fed officials did not have to worry about fallout from a trade war on those occasions. They remain extremely concerned about trade tensions undermining business confidence and, in turn, hiring and investment decisions—understandably so.
Second, while inflation is no lower now than in those episodes, the Fed’s inflation strategy is much more dovish than it has been in the past. We believe most officials want to see the trend in inflation rise above the 2% long-term goal for a while as part of an informal “make-up” strategy to help boost inflation expectations a little. The make-up strategy has replaced what was a “bygones are bygones” approach when inflation was running below 2%—officials were just trying to get inflation back to 2%. That change means that the Fed is highly unlikely to tighten again until core PCE inflation is solidly over 2%—probably at least 2.5%.