Growth and inflationIn all likelihood, the US Federal Reserve (Fed) will cut its key rates by the end of the year. Not because the economy is doing so badly. Until June, consumption and the job market have been solid, unemployment kept very low. Yet the snapshot provided by the Federal Open Market Committee (FOMC) at its latest monetary policy meeting was rather flattering. But headwinds are building up, especially those that are hampering trade, which is becoming increasingly alarming for American producers[1].
End of a cycleMonetary easing seems almost certain
The slowdown in world trade has already depressed several business climate indicators, although it has yet to carry over to GDP, which rose at an annualised rate of 3.1% in Q1. The benchmark index of the Institute for Supply Management (ISM) has plunged since last summer. In June, manufacturing ISM slipped to 51.7, which is not far from the discomfort zone at which business volumes begin to stagnate.
The Fed funds rate: what does the Taylor rule say?The dichotomy between surveys and the national accounts never lasts very long, so that the Fed expects hard data to become less rosy and is gearing its communications accordingly. Key rates are currently fluctuating within a range of 2.25% and 2.50%, and the announced rate cut seems all the more credible given that it is in line with market expectations. Since spring, there has been an inversion of the yield curve for all maturities up to 5 years: in the past, such yield curve inversions have always proceeded or accompanied monetary easing (see chart 2).
But that is not all. Although it revised its inflation outlook to 1.8% in 2019 and 1.9% in 2020[2], the FOMC indicated that it did not find wage and price dynamics to be excessive for this point in the cycle, notably with regard to the official target of 2%[3]. Unit labour costs (wages, bonuses and charges per unit of output) declined in the first quarter (-0.8% for the year in the non-farm sector), which is not very frequent and foreshadows milder inflation.
According to the Taylor rule (see box 3 and chart 2), the inflation gap (the spread between observed and expected price inflation) should swing into negative territory, and the output gap (the spread between actual and potential GDP) should indicate fewer pressures on production capacity. Under these conditions, the Fed would at least mark a pause, and is more likely to opt for a key rate cut. President Trump would be wrong to rejoice even though his wishes are about to come true: by adopting a more accommodating stance, the central bank would not be following his orders as much as providing the necessary support for an increasingly likely US economic slowdown.
No immediate appeasement with China
Despite the truce announced at the Osaka G20 summit meeting on 29 June and just after the United States imposed new tariffs on China[4], it seems vain to expect any easing of US trade tough line. First, appeasement does not fit with the political calendar. Already back on the campaign trail for the 2020 election, President Trump intends to reap as much political gain as possible from his hard-line policy, as economically risky as it might be. More importantly, the nature of US-China trade relations has changed profoundly in recent years and the two rivals are now in open competition to achieve technological supremacy.
Although the United States is still in the lead, notably in semiconductors, its supply chains are integrating a growing share of Chinese components: 85% of the taxed imports are part of the production process of major US corporations (Lovely & Liang[5]). The image of US-China trade in which Chinese textiles and household appliances are traded for American nuclear power and aeronautics equipment, which still prevailed when China joined the World Trade Organisation (WTO) in 2001, is an outdated stereotype that no longer corresponds to reality. In 2018, clothing, footwear, home furniture and travel goods only accounted for 14% of US imports from China, and their weighting has been slashed in half over the past twenty years. They have been replaced by telecommunications (the largest import category) and transport equipment, machinery and other industrial equipment, which now account for 30% of imports and are designed for all purposes, both civil and military.
The cards have been shuffled and re-dealt: the next time US trade negotiators face off with their Chinese counterparts, they are less likely to worry about the trade deficit and more about the challenges of cybersecurity and defence. Besides, when they do meet, “the security people are in the room”[6].
