The US government has set the stage for an economic experiment with its large, late-cycle fiscal stimulus, but the Trump administration’s trade agenda threatens to undermine the process as soon as it begins.
Tax cuts and spending increases are projected to fuel an ill-advised federal budget deficit for 2019 in excess of $1 trillion. With the economy operating near full employment, the extra impetus from deficit spending could cause inflation to overheat. The Federal Reserve would respond with a rapid increase in interest rates that triggers a recession. The fiscal stimulus thus shortens the expansion.
There are good reasons to engage in this experiment. First, we don’t know the extent of any excess slack that might remain in the labor market. Low wage growth and inflation, despite a drop in the jobless rate, encouraged the Fed to reduce its estimate of longer-run employment in recent years. Perhaps further declines are possible, or there might be an opportunity for pro-cyclical growth in labor force participation. Moreover, tight labor markets might induce firms to invest in more labor-saving capital, boosting productivity. Running the economy hot might trigger a supply-side boom.
Another factor in favor of this experiment is the low level of inflation. And, more importantly, inflation expectations remain well anchored. If anything, central bankers have been concerned that inflation expectations are drifting down. With such a backdrop, the Fed has room to allow this experiment to run. The extra deficit spending may also eliminate negative real interest rates as a structural budget deficit could help alleviate a global shortage of safe assets.
Finally, America’s trading partners serve as a pressure relief valve for the US economy if the demand boost stretches beyond domestic capacity. Excess domestic demand may be “offshored” in the form of increased imports, which increase the trade deficit. The trade deficit thus provides room for a margin of error by limiting excess strain on domestic resources. This will limit inflationary pressures and reduce the risk of an aggressive monetary policy.
Late-cycle fiscal stimulus is not necessarily ill-advised. If there was ever a time to run this experiment, this could be it. It might extend the life of this expansion and leave the Fed better prepared for the next recession.
The Trump administration, however, could easily shift the odds against this outcome. President Donald Trump is reportedly considering imposing steep tariffs on steel and aluminum imports of 24 percent and 10 percent, respectively. It is difficult to overstate the destructiveness of such a policy. In recent years, imported steel has accounted for more than 30 percent of US consumption. A steep tariff will undoubtedly impose higher costs on a large swath of the US economy.
While steel companies will benefit from higher prices, manufacturing more generally will suffer. Manufacturers of goods from automobiles to washing machines will feel the pain -- in the latter case, offsetting the benefit of recent tariff increases. The new tariffs might backfire in other ways as well. Manufacturers would have an incentive to offshore their production to take advantage of lower prices of materials in other countries. The construction industry, also a heavy user of steel, would be under pressure to push through higher costs to consumers. Our global trading partners may retaliate, limiting opportunities for US exports. With this administration, there is a good chance that any retaliation would be met with fresh trade restrictions.
Trump ran on a promise to reduce the trade deficit. Following through on this promise in the face of a stimulus-induced economic boom will only reduce the prospects for US growth by aggravating the supply-side constraints on the economy, forcing inflation rates higher and putting the Fed in the position of choking off growth or letting inflationary pressures build. Both outcomes would render the great fiscal policy experiment a failure.
Tim Duy
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy’s Fed Watch. -- Ed.
(Bloomberg)
