Things I Worry About
There’s certainly no shortage of things to worry about, as we are frequently reminded. But most of the issues are fairly widely recognized and are clearly on the to-do list of policy makers. There’s no assurance good solutions will be found, but well known problems rarely cause significant meltdowns in the market. So I worry more about risks I see that don’t garner adequate attention in the market. At the top of my list is a strong economy that pushes up inflation and forces the Fed to hike interest rates far more than expected by investors. So Friday’s employment report is a meaningful hurdle for me.
The Trump administration has implemented large deficit financed tax cuts to stimulate economic growth when labor is already scarce. Sharply reducing the corporate tax rate was an excellent policy move to improve corporate incentives for investment, but it would have been more appropriate to offset the revenue losses by ridding the tax structure of unproductive tax loopholes or severe complications, like the AMT. Growth was invigorated fairly quickly by the fiscal stimulus, as predicted by economic theory, but another consequence, also predicted by theory, is that inflation pressures would increase. Since inflation has considerable inertia, it was unlikely to react as quickly as growth. But react it should. So in my mind, every single employment report could reveal the inflationary effects of the new fiscal program. It is coming, even if we don’t know precisely when.
Markets remain fairly sanguine regarding the prospects for rising inflation, perhaps taking their cues from comments by Fed Chairman Powell. Though not an economist himself, his staff is chock full of top quality economists. But Powell is clearly unwilling to anticipate the data, even if his staff projects that inflation is likely to increase. So the Fed keeps normalizing interest rates, but only very gradually, while they wait for higher prices to emerge. Their hope, and also mine, is that inflation will accelerate only gradually, so it never gets out of hand before the Fed can react to rein it in. But such a favorable outcome is hardly assured. Moreover, the risk of a mistake is high, as would be the cost. This issue will surely be a topic of discussion privately at the Boston Fed conference I will attend at the end of the week.
In contrast, many investors worry about the brewing clash over trade tariffs, which might spiral into a serious global problem, but more likely, much of the action represents posturing by all parties involved. In fact, most of our largest trading partners, including Europe, Canada, Japan, many Asian countries and especially China manipulate the rules to discriminate against U.S. exports and, as equal opportunity discriminators, also against many other sources of imports. It is not entirely a matter of local taste that many cars in Italy happen to be Italian, many cars in France happen to be French, and many cars in Germany happen to be German. The Chinese are particularly egregious violators of the rules and the spirit of the rules by requiring technology transfers and requiring joint venture investments. They surely know it and it is somewhat embarrassing to be criticized so publicly for their mercantilist behavior. So I would have preferred a more subtle approach to forcing change. But having been rebuked so publicly for their manipulation of the trade system, the Chinese are likely to seek a face saving way out of their dilemma. So it seems premature to lose much sleep at this stage of the conflict.
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