Is the Fed about to be 'Trumpified'?

Luke Bartholomew

Hello and welcome to Macro Bytes, the economics and politics podcast from Aberdeen. My name is Luke Bartholomew.

Paul Diggle

My name is Paul Diggle.

Luke Bartholomew

And this is our first podcast back from our summer break. And a lot has been happening whilst we were away. And not least, we are probably very close to having a new Fed chair-in -waiting announced. President Trump has the opportunity to appoint someone to the Fed board of governors following a resignation in there, and that person will presumably end up replacing Powell when his term ends in May, if not before. We've had a lot of news on the trade war, the tariff front, a series of letters from America, to coin a phrase, news on various rates, ongoing negotiations with China. There's also been significant revisions to the employment data, which is quite significantly changed our view on how the economy has been behaving over the last couple of months. And we are starting to see some of the impacts of tariffs on inflation coming through. So, there is a lot to talk about, both in terms of the economic data, but also how it's shaping markets and policy as well.

Paul Diggle

Yeah, and I think the place to start, Luke, is with the tariff developments, because since we last spoke about tariffs in the podcast, we had both a flurry of tariff letters in early July telling countries about their new updated reciprocal tariff rate, and then a deadline of the 1st of August, where many new tariff rates were settled on. But also, some additional framework trade deals were struck. And notably, Japan and the EU both did deals with the US, where the US would impose 15%, roughly on average, on most goods tariff rates on Japan and EU. And they, by contrast, will keep tariffs on the US at [a] minimum. And they've also committed to investment deals, and in the EU’s case, a certain amount of, or quite a large amount of, energy procurement and also defence procurement. But I think the big change that has happened is that actually the new structure of the US tariff regime has become clearer in the interim, even as the US tariff rate itself – the weighted average tariff rates – clearly stepped up, uncertainty about what the overall regime, or shape of the tariff set up under Trump will be, has actually clicked into place. And in particular, the landing zones, look something like this: a 0% rate on the USMCA countries. So, Mexico and Canada – the North American free trade area. So, you can largely put aside the threats of 35%, or so, tariffs on Canada, you know, continued threats on Mexico, because USMCA trade, which is a growing share of North American trade, is essentially tariff-free and likely to remain so. Then the next sort of tier is close geopolitical allies with whom the US, from its perspective, runs a trade surplus, [xxx] example being the UK, where there's a 10% tariff rate. Then you get the allies, who are running, with whom the US is running a trade deficit – Japan and the EU – at 15%. Then the next tier is a variety of East Asian economies, often running quite large deficits from the US's perspective, who has around 20% on average, where there is also additional 40% trans-shipment tariffs to discourage the rerouting of exports from China. And then, with some uncertainty about quite where it's going to land, there's this final bucket of China, where it looks like a 40% tariff, right, may eventually be the ending point, although those negotiations are still ongoing.

Luke Bartholomew

Yeah. Notwithstanding that uncertainty on China, Paul, I think you are right to say that uncertainty in general has come down quite significantly. And why that matters so much is, as we've talked about before, one of the main channels through which this tariff stuff affects the economy is just through that elevated uncertainty. When uncertainty is so high, it's extremely difficult for firms and households to take big, lasting economic decisions. Think of hiring decisions, investment decisions, big, durable purchases. When uncertainty is so high, there's an elevated option value, if you like, in waiting to see how things resolve before making those kind[s] of decisions. So even though we are moving to a world in which tariffs are going to be materially higher than they were before, just the fact that there's a better sense of where it's going to land, the uncertainty has come down. Perhaps that makes it easier for both economic actors and the market in general to, as it were, move on.

Paul Diggle

And we can measure that uncertainty. Economists have these often news-based, headline-based, word-count based measures of economic uncertainty. And they've come down, [the] US Trade Policy Uncertainty Index, which we track, has come down. And I think that reduction in uncertainty helps explain, to some extent, the price action of the US dollar. Because remember, the dollar initially appreciated substantially when Trump won the election on the expectation of stronger growth, and indeed, an expectation of higher tariffs where, which, the model tells you, the Mundell-Fleming model, tells you should result in the appreciation of the currency imposing the tariff to partially offset the tariff increase. But then post Liberation Day, because the tariff increase was so large, because the uncertainty was so pronounced, because consensus forecast for the US economic outlook were being revised down so rapidly, because the US was seemingly becoming a much less attractive place to deploy capital. The dollar then entered, a sustained period of depreciation, and at least until late July, that actually went through a bit of a partial reversal as these trade deals were struck, and as the level of uncertainty came down. We had a period at least where the dollar resumed trading in line with the theoretical or model-based approach, where high tariffs mean, actually, currency appreciation. Now so much has happened. The story has moved on again since, as we'll get onto, the growth data, the payrolls data maybe changed that story again. But even as the growth shock from uncertainty is now reducing, it is important to say that the real income shock, the hit to consumers’ real disposable incomes from tariff-induced inflation, is probably only just getting under way. So, there are still headwinds ahead for the US economy.

Luke Bartholomew

Yeah. So just to spell that out very clearly, inflation has now started to rise and is likely to rise further as those tariff effects begin to show through. I mean, already there were signs that goods price inflation is picking up quite significantly in the latest report. And that's an obvious place to look for tariff impacts. And quite notably, at the same time, as goods price inflation was picking up, services inflation, which had been a large reason why inflation has been quite sticky over the last couple of years, quite difficult to get it back down to target, that had returned to something much more like a target-consistent rate. So, it really does look like it is a tariff-related problem now that's causing inflation to pick up. And the reason it's very likely that it would increase further as we go through the next few months, is because the full impact of tariffs hasn't been felt on goods prices, as yet, for a variety of reasons. First, firms were able to stock up on inventories in the runup to the various tariff announcements and have then subsequently run those down. And also, because there was a pretty significant wedge between the so-called de jure – the legal or the announced tariff rate – and the de facto tariff rate, the actual tariff rate that was being administered at the border. And there are various reasons for that, the de minimis exception for various goods, the fact that goods in transit were also exempted as well. The trans-shipments that, Paul, you were talking about there, allowing some tariffs to be avoided. And then just the volatility around all of these announcement, this uncertainty once again made it very difficult for customs officials to know what tariff rate should be charged. But all of those things are now starting to fade, the de minimis exceptions are closing. Trans-shipment is being cracked down on. The volatility, we think, we hope, does seem to be fading. So, for a variety of reasons, it is likely now that the de facto tariff rate is going to converge higher to the de jure rate. And so, there is further price appreciation that's going to occur through that channel. But what's crucial is that this, I think, should still be thought of as a one-off shock to the price level. So, to use language that's perhaps rather dangerous, given the experience of the last few years, this is likely to be a temporary, or transitory, increase in inflation rather than one that's permanent. But what's crucial in that actually occurring, that it is just this one-off price level shock, is that inflation expectations remain anchored, and that the Fed sets policy in a way that keeps this just a transitory, or temporary, increase [in] inflation. So, the Fed can't just sit there and act as if inflation will be temporary, [it] almost has to set policy in such a way to deliver on the fact that this inflation is only transitory.

Paul Diggle

Yeah, I mean a complicating factor there for the Fed is that it doesn't just target inflation in the way that many central banks do. It has a dual mandate. It's tasked with ensuring full employment as well as price stability. So, it needs [to] take account of the activity data there. The developments over the past month or two have been pushing in the opposite direction, in the direction of easing monetary policy, rather than keeping it at this current restrictive level. And in particular, GDP growth has been slowing. You won't see that if you just look at the US Q2 GDP number, which in fact was a pretty strong 3% annualised. But that largely reflects the distortionary impacts of tariffs, how they reallocate activity over time. So, Q1 when there was a lot of that inventory build you were talking about, Luke, and front-running of tariffs saw a large increase in imports into the US that weighed on measured GDP growth because the offsetting rise in inventories, wasn't actually being picked up in the data. And then there was this payback in Q2, where Q2 was much stronger. But a simple way to average through that effect and actually see what's happening with underlying growth. Well, there’s a few different ways. You could simply take the average of GDP growth over Q1 and Q2, and that was about 1.2% annualised. Or you could look at so-called final sales to domestic purchases, a method of tracking activity that strips out net trade and a few other volatile components. And that also grew by 1.2% in the second quarter. So, everything is telling us that the pace of US GDP growth has stepped down from last year's 2.5% or so. Nearly half and is running, indeed, around half of the trend growth rate. And then further adding to this picture, of the slowing activity side of the economy has been the latest labour market data, which you were flagging at the start, Luke. The payrolls growth has taken a big step down. Now, a headline July payrolls number was 73,000. That's a softish but by no means disastrous number. But the real story for markets was in the revisions to the historical data, where, some quarter of a million jobs that we had thought had been created over the previous two months were actually just revised away, were shown to be a mirage, such that the average rate of payrolls over the previous three months in the US was just 35,000. So that whole post-Liberation Day strength, puzzling strength for the labour market, gone. And actually, what we see is a big stepdown in the rate of payroll growth. Now, revisions are a constant challenge in macro-economic data. People often like this to, compare this to driving, by looking, sort of, in the rearview mirror. You know, you're always looking at historical past data, never completely in real time. And that data is actually subject to revision as more survey respondents, respond to the data, for example. And that's become a bigger problem still post-pandemic, because response rates to the Bureau of Labor Statistics surveys, or in the UK, the Office of National Statistics surveys, have plummeted – making revisions more problematic. And those revisions are probably pro-cyclical. That is around turning points in the economy, they are big and they exaggerate the turning point. Once you get, or they show the turning point to be bigger once you get all the data in. Yeah, imagine you are a struggling small business owner. It's not top of your priority list to fill in a survey from the statistics authority, especially if you are having to cut jobs. Now, maybe you come to fill in that survey later. You send in a pretty downbeat set of responses and if everyone's doing that, and in part this downward bias to revisions at turning points, I think that is what's happening at this point in time. Now, further sort of wrinkle in this story is that the decline in net migration into the US, which is a result of the tightening of border restrictions, the increase in deportations under the Trump administration, means that the breakeven rate of payroll growth – the sort of, the par rate of job creation [in] the economy – has also stepped down. So that's maybe 50 to 75,000 a month now, lower than in the era of very strong net migration into the US economy. So, 35k is still weak, is still subpar in that context, although it's not yet at least recessionary. So, it's consistent with a modest rise in the unemployment rate rather than the labour market completely falling off a cliff.

Luke Bartholomew

And then to add one further complication to the way in which we might have to interpret data in the future isn't just these legitimate issues with revisions that you are describing, Paul, there. I think a risk that seems to have emerged is the politicisation of the data gathering and reporting process as well, because, of course, President Trump fired the head of the Bureau of Labor Statistics, Erika McEntarfer, on Friday following those big revisions suggesting that she was politicising them in such a way to make Republicans and him look bad. And suffice it to say, this is not a good look. From the perspective of investors, I mean, it's kind of basket case economics to really be going after your data providing services. The kind of thing that Argentina has done previously – lying about inflation data. Famously Greece massaged some statistics about debt levels to get into the Eurozone, which I think, it's fair to say, did not end particularly well. And look, I mean, I think the US is probably a long way from being at a point where it's outright lying about the data and, you know, we have to not entirely trust every bit of data that comes out. But perhaps an analogy, gets a little bit more about the concerns, is the way in which the Truss Government wanted to sideline the Office for Budget Responsibilities in the runup to the mini budget. And obviously, this is not a particularly auspicious analogy when it comes to market reaction. The reason I pick that out, because I think it, you know, it also shows a certain attitude towards economic expertise, economic institutions and the way in which political power can be used relative to those existing institutions. And yeah, markets don't tend to take that particularly well. Now, you could argue that the US has rather more rope to play with than Argentina, Greece or even the UK. As we've talked about many times, it has this exorbitant privilege, the importance of the US economy, the dollar to the global financial system, means that some of these things can be shrugged off by investors in a way that it's harder to do, with other smaller economies. But nonetheless, part of the very reason that the US has this exorbitant privilege is because it has trusted economic institutions. And so, to undermine those does seem to be playing with fire a little bit.

Paul Diggle

Yeah, to come to another trusted economic institution, which is, to say the least, facing a degree of political pressure, let's talk about how all this cashes out for the Federal Reserve. Because, as we said, the data is pushing them in two different directions. The stagflationary whiff of the inflation and the growth data mean it's not obvious what they do with policy. And then there's these political appointments. And the political pressure on Powell that you were talking about at the start, you talk about, I mean, the immediate debate in markets, at the Fed, is will they cut interest rates at their September policy meeting? The 8th July policy meeting was actually surprisingly hawkish, aspects of its communication, despite the fact that two Fed governors voted for an immediate rate cut, a pretty unusual dissent from members of the board of governors. Powell’s communication was fairly hawkish, talking about needing to wait and see, how large the price impact from tariffs is, saying that actually they were looking through inflation by not hiking interest rates at this point, which was a notably hawkish thing to be talking about it. But post the payrolls data and the way in which that's really changed the narrative, how to read the US economy in the cycle, market pricing is sort of well up there for a September rate cut. There's even some talk about a possible large, jumbo, 50 basis point rate cut. Remember, they started their rate-cutting cycle [in] September last year with a 50-basis point rate cut, feeling they got behind the curve somewhat of the moderation in the economy. So potentially they'd be mirroring that. There’s even being some, I think, rather breathless talk about an intra- meeting, emergency rate cut, although I think we can put that aside. Of course, a September rate cut – a 50-basis point rate cut – would come as music to the ears of Trump, who's been lobbying Powell publicly and, you know, presumably privately on that visit to the Eccles Building to check in on the state of the US Fed building’s renovations. But I think it's not so obvious, given the stagflationary whiff to the data, that they are all in on an immediate and large rate cuts. The Fed is, I think, scarred by the previous inflation overshoot by having initially labelled that as transitory as you, you were talking about Luke, rather than recognising the persistence of the post-pandemic inflation overshoot. So, there is certainly a part of the committee and Powell is amongst those, albeit his authority may be waning at this point, who are in the wait-and-see camp. But, you know, we need to hear more communication from Fed committee members to see if they, if that narrative has changed with this big stepdown in the pace of employment gains.

Luke Bartholomew

And just to spell out there, Paul, clearly why Powell’s authority might be waning. I mean, the reason for that is that, as I said at the start, we could be on the verge of hearing who his likely successor is going to be. It does seem that some of the threats to fire Powell immediately have faded a little bit. The Supreme Court heavily suggested it would carve out an exception for the Supreme Court, making it difficult for the president to fire anyone there, and also because of some concerns, about the market reaction to such a decision as well. I think Trump might have been talked off the ledge there by Bessent and others. But the point is that probably also isn't necessary anymore, because Adriana Kugler, who is a governor of the Fed, has resigned. And so Trump gets to appoint a new governor to replace her. And presumably that person would then become governor when Powell’s term expires in May. At that point, probably Powell would step down. That's been traditional for Fed chairs over the last few terms. But that isn't guaranteed. But some of those issues are now broadly sidestepped because, yeah, Trump can put this Kugler replacement in and that person will be, it will be clear to the Fed staffers, other policymakers, the market, that this person will be setting monetary policy as head of the Fed from May next year. So, then the question is, well, how much influence will that person have as Fed chair? I mean, in one reading they are but just one of 19 members of the FOMC – 12 voting members made up of the various governors, the president of the New York Fed, in a rotating cast of other regional Fed presidents as well. So yeah, just one vote, you might think. And so, you know, if that person wanted to set policy in a way that Trump approved of, but the other members of the Fed thought was inappropriate, perhaps they could be voted down. I wouldn't want to lean too hard on that kind of institutionalist reading for a variety of reasons. First, because it isn't really the case that the Fed chair is just another vote, they’re even more than just first among equals. I think it's fair to say, you know, the Monetary Policy Committee at the Bank of England is a bit more the case, that the governor is just one of nine votes in that case. And indeed, the governor can be, and has been, in a minority in the past – so not got the policy that they wanted. But that just isn't the way that the Fed runs. It is a much more hierarchical organisation that, broadly speaking, it's about finding agreement around what it is that the Fed chair wants to do, and the policy institutions act to support that person. So, I think they would have, a serious amount of influence. It could be that other Fed policymakers resign in the course of that. But by hook or by crook, I think that person would be able to have a significant degree of power in setting policy. So, then the question is, well, then should we be taking seriously what Trump has talked about around interest rates getting down to 1% or so, which he has, you know, with some of his whiteboards and, and markers suggested, is where US rates should be. And having said that the Fed chair has a lot of power over the institution of the Fed. There is still one very important limiting factor, and that is the market itself. If policy is set in a way that it is not credible, then inflation expectations will pick up significantly. Term premia will rise significantly. So without, you know, really quite material financial repression, the limiting factor on where interest rates can get to is, is market reaction and how the economy responds. And I think that would be what stops rates falling to 1%. But I think it is pretty reasonable to think that monetary policy will end up being set easier than it otherwise would have been, with this new Trump appointee, as and when they get power. But whether that's sufficient to take interest rates both at the front-end and at the long-end of the curve, so long-dated interest rates, low as well it's quite a different matter. Because if it does undermine credibility, inflation expectations do increase, then the US will be facing higher government financing costs, not the lower costs that Trump wants.

Paul Diggle

All right, well I think that's about all we have time for. Huge amount going on in macro markets and no doubt we'll return to these issues as we learn more about the composition of the Fed and the evolution of the US economy. But for now, please like and subscribe to Macro Bytes if you haven't already. And goodbye and good luck out there.

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