U.S. momentum good enough for trade battles?

Will (a) the Trump administration’s trade warmongering turn into a major drag on U.S. economic growth, not just political theatre? Or (b) will actions and retaliation be fairly limited, averting a significant loss of confidence in markets and keeping growth on track for a pick-up this year? Our forecast counts on “b,” but we admit to a bit less confidence in that view as we see the policy process play out in Washington.

We have been—and still are—quite positive on the outlook, but there are always risks. We expect real GDP to rise 3.0% in 2018, lowering the unemployment rate to 3.4% by year-end. We expect the further tightening of the labor market to add to upward pressure on wages. We expect core inflation to rise as well, with the 12-month change in the core PCE series up 0.5 points to 2.0% by year-end. We expect Fed officials to tighten four times this year. We expect them to tighten four times in 2019 as well, as inflation keeps edging up.

Our fairly optimistic outlook reflects our view that there is “too much stimulus in the system.” Ill-timed stimulus from fiscal policy is adding to still-stimulative monetary policy. Financial markets look as accommodative now as they did when the Fed began the tightening cycle. The global economy has become increasingly supportive as well.

Our expectation—hope—has been, and still is, that the administration’s trade actions will be narrowly targeted and not seen as leading indicators for broader measures or, ultimately, a confidence-sapping trade war. Some narrowly targeted actions were initiated during the Obama, Bush and Clinton administrations as well, and fallout was generally limited. Similarly, the Trump administration’s previous actions on lumber, solar panels and washing machines were largely shrugged off in financial markets. The risk of an outsized reaction grows each time a new measure is announced, however. The reaction could be especially large if it is perceived as broad, such as relating to NAFTA or Chinese imports in general.  Trade policy is likely to remain in focus in the weeks and months ahead, as trade with China, Mexico and Canada move into the spotlight.

In the meantime, the economic data continue to signal more than enough strength to keep the unemployment rate trending down, adding to upward pressure on wage gains and inflation.

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