The Fed will squeeze in cuts in September and October, but after that, the environment will make further easing challenging.
That’s the message from Goldman’s Jan Hatzius, whose latest note carries the rather ominous title “Less Growth, More Inflation”.
Hatzius begins by acknowledging that, for now, the US economy is still in something of a sweet spot. “All things considered, we think underlying growth in ex-census jobs is now around 150k, still above the estimated 100k breakeven rate and thus consistent with gradual labor market tightening”, he writes, commenting on Friday’s disappointing August jobs report and noting that “broad activity indicators show US growth close to its 1¾% potential rate, with strength in consumption and the service sector offsetting stagnation in business investment and manufacturing”.
Still, things are slowing. Goldman’s CAI was at 1.4% for August and real GDP growth is tracking just below 2% for the third quarter.
There’s no mystery here. “The most plausible reason for the slowdown is the escalation of the trade war since May”, Hatzius cautions, before reminding market participants that the problem isn’t so much the mechanical impact of the tariffs and non-tariff barriers, but the difficult-to-measure knock-on effects.
“Most of [the ½pp hit to US growth in the second half of 2019] comes not from the mechanical effects of tariffs on trade flows and real income, but from relatively hard-to-measure channels such as financial conditions, sentiment, and uncertainty”, he writes.
There’s plenty of evidence to suggest that this uncertainty is starting to bite. University of Michigan consumer sentiment plunged to a Trump-era low in August and recent poll data shows that for the first time since the election, more Americans think the economy is getting worse than getting better. The same poll shows voters think the president’s policies are hurting, not helping – that’s also a first.
Turning to inflation, Goldman sees core PCE accelerating in the near future.
“Beyond September/October, we think the environment will become less supportive for further Fed rate cuts, mostly because core PCE inflation will likely turn sharply higher on a year-on-year basis”, Hatzius says. In addition to “outliers” falling out of the YoY prints, the tariffs should finally start to make themselves “heard”, so to speak.
“The tariffs are about to show up more clearly in the PCE numbers, starting with the September release published in late October”, Goldman says, adding that “although it is true that tariffs are equivalent to indirect tax increases and therefore less relevant for monetary policy than other sources of inflation, it will become harder to make a case for further rate cuts when core PCE has a 2-handle, as we think it will by early next year”.
That is a veritable nightmare scenario for Trump, although Goldman doesn’t pitch it that way. If the Fed were to cite tariff-related inflation as a reason for not being able to cut rates further after assumed cuts in September and October, the White House would be beside itself. Trump and his advisers have repeatedly claimed that the tariffs don’t raise prices for US consumers and Peter Navarro has defended that line on national television even when presented with irrefutable, on-screen evidence to the contrary. Recall this moment from an August interview with Fox’s Chris Wallace, who cited Goldman and the Labor department while chatting with Navarro:
As ever, the administration is prepared to go down with this ship. And they may have to, depending on how things develop.
Of course, Trump can steer the Titanic away from the iceberg any time he chooses simply by deescalating things with Xi. So far, he’s doing the opposite of that, but Goldman thinks a consumer revolt might change his mind.
“[Trump’s] net approval rating on trade policy is already in negative territory, and further deterioration is likely once consumers see the inflationary fallout from the latest steps”, the bank says, adding that his net approval rating on the economy is still positive (depending on the poll, by the way), something Hatzius expects the White House will “try to protect… by de-emphasizing the trade war in what promises to be a hard-fought election campaign”.
As far as 2020 goes, Goldman says the outcome is still “too close to call at this point”.