Weekly Economic Trends and Indicators
Last week, we pointed out how economic events since the start of this year have contributed to an increase in uncertainty concerning the economic outlook. One of the more visible aspects of that story has been the various announcements of tariffs. The prospect of higher tariffs has had significant effects on inflation expectations, the value of the dollar and consumer sentiment. This week, in the second part of this two-part series, we consider how these factors combine to affect the outlook.
Tariffs can cause inflation, but not in the usual way
At a basic level, tariffs raise the price of imported goods for consumers—which looks like inflation. However, it is a different source of inflation than an injection of money into the economy such as we saw during the COVID-19 recession. Inflation driven by monetary policy will persist until the growth of money is slowed. In contrast, the prices changes from tariffs tend to be one-time changes rather than changes in the growth rate of prices. However, because different prices are changing at different times and because there is still an adjustment process, it can be hard to tell the difference between this and monetary inflation.
Because of our recent experience with inflation driven by monetary policy, consumers may be more wary of anything that looks inflationary. Hence, the sudden and dramatic increase in inflation expectations which have put downward pressure on the dollar and rattled the bond market.
The value of the dollar is a key indicator
Changes in the value of the dollar can be extremely helpful in seeing which way the economic winds are blowing. Historically, the dollar strengthens in times of global economic crisis as the United States is seen as a safe haven for investors throughout the world. Dollars are used to settle international transactions, and the dollar retains its importance as a reserve currency. On the flip side, the dollar weakens during times in which U.S. interest rates are lower than those in other major world markets such as Japan and Europe as investors seek higher rates of return overseas. Inflation expectations can also weaken the dollar through their effect on the bond market. Global demand for U.S. bonds falls when inflation expectations rise, and this reduces demand for dollars. The interest rate must then rise to soak up the excess dollars in the market. Something like this happened about two weeks ago. Amid rising inflation expectations and a general sell-off of U.S. assets (for this and other reasons), long-term interest rates rose suddenly. This, in turn, drove mortgage rates higher and threatens to reduce economic growth this year.
Tariffs large enough to close the trade deficit would dry up global trade as well as dollar demand
With all of this in mind, it becomes clear why the tariff talk has sparked this much concern. Smaller, more targeted tariffs would be less disruptive to markets and would still potentially move some manufacturing activity, on the margin, back to the U.S. This is what the markets were expecting after the election—and in fact, the expectation of modest tariffs actually boosted the dollar. However, tariffs as large as those announced on April 2nd would be large enough to dramatically alter world trade flows. The end result would be less trade worldwide and lower demand for dollars with all of the associated negative consequences described above. That possibility was enough to send markets reeling and cause forecasters to raise their recession probabilities.
As trade negotiations between the administration and multiple countries are still ongoing, it is unknown what the final outcome for tariffs will be. Modest increases in tariff rates combined with exceptions for goods in the supply chain for which production cannot easily be moved here would lower—but not eliminate—the recession risk. This would also help alleviate consumer worries about tariff-induced inflation, thus stabilizing the dollar and preventing a spike in interest rates.
As it stands, the added uncertainty has raised the probability of recession above the baseline, and each new round of uncertainty adds stress to an already stressed economy. As a result, growth is likely to be at least a fraction of a percent slower this year than we expected at the start of the year, but a recession is still avoidable if trade negotiations are successful.
Watch for our Quarterly Market Report in May for an update and further details on how these events could affect the local economy.
Next week: International update
