On the Minds of Investors
Q: Will tariffs lead to an increase in inflation and force a rate hike?
Trade tensions between the U.S. and China continue, with little sign of resolution. Talks appear to have stalled and neither side appears to be a in a rush for another round of discussion. The next likely juncture for any clarity is a possible meeting between the two countries’ respective leaders at the G20 meeting in June. Tariffs appear to be a fixture of U.S. trade policy going forward and are unlikely to be completely removed any time soon.
Higher consumer prices from rising tariffs have raised worries about higher inflation and a policy response from the U.S. Federal Reserve (Fed). The Inflation rate in the U.S. has been fairly benign, in April core CPI inflation rose 2.1% year-over-year and the March core Personal Consumption Expenditure deflator index was up only 1.6% year-over-year. Hardly worrisome given the Fed’s 2% target. The concern is that an increase in price on imported goods would mean that businesses and consumers will have to pay extra if importers pass along these costs. The bad news for the U.S. consumer is that this appears to have happened, with almost the entire price burden being placed on their shoulders. Looking at the categories that have been impacted by the tariffs separately, including laundry equipment and other appliances, furniture, auto parts, materials and others, prices appear to be rising fast and the impact on consumers could be worse if the trade conflict escalates with retaliation from both sides. The tariffs implemented to date have largely avoided consumer related goods, accounting for only about 25% of the items being targeted. If the proposal to place tariffs on all imports from China is enacted then more consumer goods will likely see a price rise. The concern here would then be that inflationary pressures could rise and in the worst case scenario, forcing a reaction from the U.S. Fed.
If the trade war causes growth to fall, inflation to pick up and rates to rise, this would obviously be a negative. However, we currently see this worst case scenario of higher inflation and lower growth due to the trade war as quite unlikely. The potential costs of the threatened tariffs still only amount to around 0.2% of consumer spending and any increase in consumer price inflation is also calculated to be around the levels of tenths of a percentage point. The impact would also be a one off, only showing up in year-over-year comparisons for 12 months. In our view, the bar for the Fed to make a move is much higher than this level. Inflation could pick up slightly in the next 12 months, but then we believe the Fed will recognize this as a one-off event and focus will still be on growth. Tolerance for higher levels of inflation is likely to win over restarting the rate hiking cycle and potentially dragging down U.S. economy.
EXHIBIT 1: Higher tariffs leading to higher inflation
U.S. Personal consumption Expenditure Index for core and selected categories, February 2018 = 100
Tariffs are escalating but the inflation impact appears low for now. Currently, consumers are burdening the extra costs of tariffs but this may shift in the future. Importers may absorb more of the costs or pass them on to consumers as the situation develops further. Market impacts may be hard to judge and will vary from company to company and by sector depending on pricing power.
Unless these effects on inflation become significantly more pronounced, the Fed is likely to stay on hold. As such, interest rates look set to remain low and the risk of a scenario where the Fed is forced to raise rates, dragging down growth and leading to recession, is still unlikely this year.
The trade conflict continues to add uncertainty to the global outlook and growth prospects, but our view is that an eventual trade deal will still be reached, as a total breakdown in talks will see both China and the U.S. suffer. The path to any resolution is still uncertain and with such volatility, we still advocate for a balanced approach between equities and fixed income.