Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate on November 26th.
We are in a trade war, with no sign of peace breaking out anytime soon. By now the disruption to trade looks to be extensive enough to factor negatively into forecasts for economic growth. Does that mean that the Fed should change its plans to continue gradually raising interest rates? No. Monetary policy can’t mitigate the damage done by foolish trade policies.
The biggest trade conflict is between the US and China. The US is scheduled in January to raise tariffs on $250 billion of imports from China, from 10 per cent to 25 per cent. President Trump has also threatened to impose new tariffs on the rest of Chinese imports, $267 billion. He meets with Chinese leader Xi Jinping on the occasion of the G20 meeting in Buenos Aires, which starts November 30 (after having skipped the Asia-Pacific Economic Cooperation meeting, November 17-18, in Papua New Guinea). Some hope that the two leaders will achieve a break-through in the trade impasse. But that seems unlikely. The apparent demands on the US side are either beyond the capacity of China to deliver – an elimination of the bilateral imbalance – or are too fuzzy to be verifiable in the short term – such as ending forced technology transfer.
Implications of Trade War for Short-term GDP Forecasts
On the one hand, it is a truism among the economically literate that there are no winners in a trade war. On the other hand, it is also true that even numerical impacts that are relatively large for individual sectors like soybeans tend to translate into relatively small effects on quarterly GDP, at least in the short run. The discrepancy is in part due to the dominant share of services in the modern advanced economy, as opposed to manufacturing and agriculture. But even in the 1930s, the infamous Smoot-Hawley tariff and ensuing foreign retaliation is judged by economic historians not to have been among the largest fundamental causes of the Great Depression. As the trade war grows wider and deeper, however, a negative toll is beginning to show up in forecasts of economic growth around the world. The OECD on November 21 became the latest international agency to mark down its global GDP forecasts (to 3.5% in 2019 and 2020, from 3.7%), particularly in China, the US, and Europe.
The trade war appears to be among the reasons for a renewed slowdown in Chinese GDP, with growth forecast to fall to 6.0% in 2020, from 6.6% in 2018. The Chinese slowdown in turn has spillovers for other countries, especially those that export commodities. Europe has already slowed down in 2018, with Germany even reporting a surprising negative 3rd quarter growth number. Trade is among the reasons: reduced demand from China, unprecedented uncertainty in US trade policy, and the imminent prospect of a hard Brexit.
Of course trade is just one of many factors driving economic growth. US GDP has been strong this year. The 2018 expansion has been largely driven by late-cycle fiscal stimulus: tax cuts and spending increases since December 2017. But the effect of the fiscal stimulus is expected to fade soon. The forecasts show US growth falling to 2.1 % in 2020 from 2.9 % in 2018.
Classical gains-from-trade arguments focus on the damage that protectionism does to economic efficiency, productivity, and the standard of living (especially in the long run)? But not everyone agrees that tariffs are bad for the economy. What if one focuses on net exports, following Keynesian or even mercantilist arguments? Might one then expect to find that Trump’s tariffs stimulate US economic growth, with others’ losses being America’s gains?
Trade theory, macroeconomic theory, and the experience of the last year all suggest that Trump policies are not helping the US trade balance. If anything they are hurting it, when one includes the effects of Trump fiscal policies. The US trade deficit reached $54 billion in September ($648 billion per annum), exceeding in nominal terms the deficits recorded every month from 2009 to 2017. The tariffs are presumably having a negative effect on US imports, but negative effects on US exports are as large.
This was predictable, for several reasons. In the first place, when incomes among trading partners slow, they buy less from the US. Second, China and other countries have retaliated against US goods with tariffs of their own. Third, as a consequence of the rapidly rising US budget deficit — a remarkable policy in a country at full employment — an excess of spending power has spilled over into imports from abroad, heralding the return of the famous “twin deficits.” Fourth, the dollar has appreciated (not just against China’s yuan, but against most currencies), making it more difficult for US firms to compete on world markets, again in line with theory.
Implications of Trade War for Monetary Policy
To the extent that the trade war implies slower growth, is that a reason for central banks to follow easier monetary policy than they would otherwise? Is it a reason for the Fed to halt is gradual path of interest rate increases (including the fourth rise of the year that is expected to come out of its meeting in December)?
Some recent commentary seems to presume that this is a direct implication. But it is not. While slower growth might seem to call for easier monetary policy, the protectionist measures also work to increase prices, which has the opposite implication for monetary policy. True, the effect on inflation has been small so far. But there is more to come. Forecasts from Goldman Sachs show a base case (with the 10 per cent tariff on the rest of Chinese imports taking effect in early Q2) in which the effect on US core inflation reaches 0.17% in June 2019. In the case where Trump follows through on his threats to put tariffs on auto imports generally (citing a supposed threat to national security) and to apply the 25% tariffs to all US imports from China, Goldman forecasts that the impact on US core inflation would reach 0.30% by September 2019.
The right way to think of adverse trade developments is as a negative supply shock. Skillful monetary policy can help offset a negative demand shock, but can do little or nothing to offset a supply shock. The best one can do is passively accept the hit partly in the form of slower growth and partly in the form of higher prices. To apply monetary stimulus in an effort to prevent slower growth would result in higher inflation. (Similarly, to accelerate monetary tightening in an effort to offset the effects of import tariffs on domestic prices would have a negative effect on GDP.) The Fed understands this. Indeed, if the Fed were to keep interest rates at historically low levels in an attempt to artificially prolong the period of high growth (for example, succumbing to norm-breaking pressure from President Trump), then the inflation impact would be higher than the numbers in the Goldman Sachs forecasts.
Brexit and the Bank of England
Trade considerations are not the biggest factor in the US economy. But they are dominant in the United Kingdom these days, as a result of Brexit. Political chaos has followed the June 2016 referendum in which 52% of voters chose to leave the European Union. The feared negative effect on growth has not yet materialized. This is thought to be, in part, because the Bank of England eased monetary policy. (Inflation rose, from near-zero in 2015 to near 3 per cent in 2017.) But it is also because the supply shock did not really hit when the vote took place. Arguably, the only impact so far has been on demand, for example as firms cut investment in anticipation of the coming rupture. Such a fall in demand is something that the central bank can work to offset.
Next time could be much worse. The actual exit of Britain from the EU is due to take effect in March 2019, which is rapidly approaching. The UK may accept the last-minute deal with the EU that PM Theresa May has negotiated (but that has little domestic support). Less likely, Britain could change its mind, in a new second referendum. But if the UK “crashes out” of the European Union in March with no arrangements to preserve open trade flows across the British Channel, monetary policy cannot prevent injury to GDP, as Governor Mark Carney has recently warned.
Current trade policies are working to reduce real incomes in the US, Britain, and many other countries. But the problem is not something that monetary policy can address. The choices are up to voters and the leaders they elect.
This post written by Jeffrey Frankel.