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.
The right way to think of adverse trade developments is as a negative supply shock.
Right, just as the right way to think of positive trade developments is as a positive supply shock. Over the long run trade policies affect potential GDP.
Skillful monetary policy can help offset a negative demand shock, but can do little or nothing to offset a supply shock.
Exactly. And as I recall our host JDH wrote a few things on this (contra Ben Bernanke) with respect to the effectiveness of monetary policy in response to oil shocks.
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.
But, but, but, Dear Leader with his ever expanding gut tells us that this is all nonsense. Who are you going to believe? Some egghead academic with fancy models, or a stable genius with seat-of-the-pants experience in bankruptcy court?
“True, the effect on inflation has been small so far. “
And yet, once again we have folks like Jeffrey Frankel wringing their hands over the prospect that people who actually work for a living might get a bigger share of the national income in a tighter labor market.
Frankel, like members of the Fed, have been fretting constantly, even going back to 2010, that rampant inflation was about to break out. At every Fed meeting, even at the depths of the Great Recession, they stated over and over that they were anxiously, anxiously, anxiously waiting for the moment to start raising interest rates.
No, thanks. You have been overly cautious and wrong about everything for a decade now and this is no time to start listening to your concerns.
If a nation can lower interest rates via monetary stimulus (see the European Central Bank) as an example, it can devalue its currency which should encourage exports and reduce imports (even without tariffs) which in theory would increase domestic employment as it lowered the trade deficit. But wait – as Jeff Frankel notes, this ain’t happening in Trump world:
“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.”
Now Trump might want to blame the FED for this but then his big gut has not digested the rest of the world around him including all the damage his own stupid policies have created. Maybe he should stop having breakfast while watching his favorite economists on Fox and Friends before his gut gets indigestion.
“A Wall Street Journal interview on trade shows Trump has no idea what he’s doing – He confuses tariffs and interest rates, and invents phantom new steel plants.”
https://www.vox.com/2018/11/27/18114141/trump-wall-street-journal-interview
“At one point during his latest interview with the Wall Street Journal, President Trump mixes up tariffs (a kind of sales tax imposed on imported goods) with interest rates, which are the extra money you owe when you take out a loan. Bob Davis, the journalist conducting the interview, corrects the president. It’s the kind of verbal slip that could happen to anyone. Except that Trump, after acknowledging the error, flips back around and makes it again later in the interview.”
My Lord – this man is an utter moron. Of course Kudlow is his economic advisor so it is moron advising moron. And yes – the Usual Suspects will likely defend this stupidity with their own stupidity.
“The tariffs are presumably having a negative effect on US imports, but negative effects on US exports are as large.”
I would like to see some evidence to support this claim.
@ Don
The USA trade deficit growing larger under donald trump (as stated in the very preceding blog post to this one) doesn’t qualify as evidence for you?? How about the following from Frankel: “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.” Don….. where the F— did you think Frankel got those numbers from??
HINT: Frankel didn’t grab those numbers from trump’s used McDonald’s cheeseburger wrapper, and not from the tag on the inside of a red MAGA dunce cap.
Don, I know you sitting all day watching FOX does nothing to exercise your brain cells, but when exactly did you stop comprehending written numbers??
I asked for evidence that the negative effect of the tariffs on US exports was as large as the negative effect on US imports. Ex post trade numbers won’t make the case. For example, the fall in exports may have come entirely from dollar appreciation caused by the fed’s increase interest rates. Of course, Frankel’s statement is technically ambiguous. But do you agree that he is saying that the negative effects of the tariffs on US exports are as large as the negative effects of the tariffs on US imports? What other meaning would you give the statement? If that is not what he is saying, then the statement is empty – for example, if the negative effect on exports is exogenous with respect to the tariff, and if the tariffs ‘presumably’ reduced imports, then the tariffs ‘presumably’ reduced the trade deficit, too.
@ Don
Only a buffoon would believe the recent increase in the trade deficit was caused exclusively from dollar appreciation. Or from the raising of rates. I don’t even like Jerome Powell as a person or as a “technocrat” (I’m close to getting mouth vomit even typing that word to describe Powell). But I will give the bastard this much–he took that fallacy trump was trying to create of using rates as “an out” for trump’s bad trade policy and stuffed it right down trump’s gullet. So–I will give Powell credit for having that much intelligence, of what little he has.
As far as Frankel’s lifted quote, you yourself call it a “claim” and then you turn right around and say it’s “ambiguous”. Taking lessons in Bill O’Reilly circle logic?? There’s not much doubt there are negative affects both for American exports and American imports. It’s not an “either or” deal. That’s what makes trump’s MAGA trade policy so utterly asinine. If MAGA trade policies are having major negative impacts on both, does it really matter which is larger?? For idiots like donald trump, maybe.
Which would I say is hurt MORE—–>> American exports or imports?? An increase in the trade deficit strongly implies exports are being hurt more than imports. Now if Menzie or any credentialed economist (Master’s degree of higher in the topic) wants to correct me on that point, I am very happy to be told in what fashion I am wrong on that. Honest to God, if someone who actually has a Master’s degree or higher in economics wants to tell me that in a ceteris paribus way I am wrong on that, I’m happy to swallow my bitter medicine of being wrong so that I can learn something.
I have admitted I was wrong on this blog before and apologized for being wrong—->> which is a whole lot better than about 98% “regular commenter” jackasses who have committed more egregious sins in reason than I have on this site.
one could plausibly imagine that don and corev are one and the same buffoon.
Unfortunately, I don’t think anyone can tell you that tariffs can’t hurt the trade balance, only that it is unlikely. (If nothing else, the adverse effect on real income should help the trade balance improve.) I doubt very much, however, that any net effect of Trump’s tariffs on the U.S. trade balance could amount to much when compared with the effects of changes in the rate of economic growth at home and abroad and of changes in exchange rates (not including those brought about by changes in tariffs).
But I hope our host will give his opinion on the logic of your statement: “Which would I say is hurt MORE—–>> American exports or imports?? An increase in the trade deficit strongly implies exports are being hurt more than imports.”
Actually real exports are up over the past 2 years while real imports are up a lot more. Of course one would expect real activity to grow with growing economies. Frankel knows this and is looking at how real exports should have increased even more than they did. After all – he does have access to some of the best models. But do you even know what you mean by “evidence”? Maybe he will write a long empirical paper for us one day but this was a blog post.
Now if you care to offer us an intelligent model and use it to produce “evidence” than stupid comments like this one might have some merit.
““The tariffs are presumably having a negative effect on US imports, but negative effects on US exports are as large.”
BTW – the seminal work on international macroeconomics over 50 years ago was written by Mundell and Flemming. And one of their celebrated theorems held that under floating exchange rates – tariffs have no net impact on net exports. I guess Frankel learned this basic theorem but you haven’t.
don: Lerner symmetry theorem, to begin with. I think in terms of magnitudes (not exact), one could get similar results by appealing to imported intermediates.
C’mon Menzie – don has no idea what Lerner symmetry even is. So let’s have him digest this mathematical exposition:
http://www2.econ.iastate.edu/classes/econ355/choi/lerner.htm
Not sure he will get it but it will keep him busy for days!
Yes – a tax on imports is equivalent to a tax on exports. My quibble is with the logic that ex post changes in the trade deficit offer proof (or even good evidence) that tariffs have had a bigger adverse effect on exports than on imports.
I apologize for some confused thinking on my part. For example, the drop in imports from China will be offset under pgl’s flexible exchange rate regime by an increase in US imports from other sources and by a reduction in US exports. So total imports fall by a smaller amount than the drop in imports from China. I was thinking (if you can call it that) that the effect on US exports would not be as big as the effect on US imports from China. So Frankel’s statement is consistent with the theory and I am accordingly embarrassed.
As a side note, Abba’s theorem (or pgl’s exchange rate effect) depends on the tariff having no effect on long-run reserve accumulations. For example, if DT’s tariff threats deter China from accumulating more dollar reserves (or if it encourages them to reduce their current holdings) it should improve the US trade balance.
This post is quite good. There were about 3 sentences that jumped out at me, among many good ones.
“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”
” To apply monetary stimulus in an effort to prevent slower growth would result in higher inflation. ”
“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.”
” 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.”
Also, 2slugbaits has already “beaten me to the punch” in spotlighting Frankel’s comments on negative supply shock and “2slugs” stating it better than I would have. In fact the negative supply shock induced by trump’s trade policies is the diesel fuel which feeds the fire of unnecessary inflation. Some Americans may notice this on the prices of their Apple products sooner than they imagine (among a boatload of other products).
I would also like to add, that certain of Menzie’s research papers (which I’m embarrassed to say my poor performing brain forgot the titles of) are some of the BEST academic writing and expositions I have ever read on America’s perennial problem with the twin deficits. If Menzie “carried China’s water” like some moronic commenters on this site believe (which about makes me want to RAGE when those implications about Menzie are made—then Menzie would have no stake/benefit in explaining the crux of America’s twin deficits problem better than anyone I am aware of ever has—>> at least in non “volume size” form.
I wonder how good those Goldman Sachs analyses of the inflation impact of the tariffs are. At first blush, I’m inclined to dismiss them on account of their illusory precision (to four decimal places??? That what .0017 happens to be). But, on reflection, I don’t think there has been much modelling of inflation rates in the United States in the last generation, certainly not under current conditions, so the problem may be graver than illusory precision. State of the art 1970s tools, and all that.
But, intuitively and on the basis solely of anecdotal evidence, I think we’re setting ourselves up for a stout bout of cost-push inflation. Every independent actor at every step in every global supply chain has to be protecting itself by building a margin (plus a safety factor) in its pricing for the tariffs. And with full employment and massive federal deficits, there is no reason to think that at least initially demand won’t be sustained in the face of those increases–at least for long enough that the habit will become ingrained among managers).
If so, well, Trump may beat the rap, but we won’t beat the ride.
Dwight: Interesting observation and comment.
I seriously doubt the US is in for prolonged period of cost-push inflation. The market structure is simply not there. Few sectors, if any, have the market power to continuously pass on cost increases.
That said, I fully expect measured inflation to increase in the wake of the import tax increases and a softening dollar. The year over year increase in the price level will provide additional justification to the Fed to keep hiking rates towards a neutral bias.
The retaliatory tariffs by China and US allies will create some extra capacity. Note that in the background, oil prices are swooning. Once WTI dips ow enough, e.g., below US$50/bbl, some of the shale oil projects on the margin will no longer be attractive. That slowdown will also create extra capacity.
I agree with Frankel’s overall thesis that monetary policy should not be used to off-set home-grown trade shocks as their impact is widely expanded and well known. (Nor should monetary policy be used to offset negative shocks catalyzed by US foreign policy decisions…. but that is another discussion.) Monetary policy should not act to enable riskier fiscal policy or compensate for a poor education in basic economics and the world view of ‘other’ peoples. Moreover, further tightening would position the Fed to better accommodate unexpected negative shocks to the economy in the future.
Otherwise, it is all very sad. This should be an era of robust economic growth for the USA and other economies impacted by the financial crisis of 2008. Slower growth, even possible stagnation are what the tea leaves are showing.