Fiscal stimulus was delivered in 2017, and President Donald Trump’s recently announced tariffs on steel and aluminium suggest trade is 2018’s priority. Whether and how it avoids the pincer will define the economic landscape in 2018.
“The US’ fiscal expansion is coming at the wrong time of the economic cycle.”
It's widely acknowledged the fiscal expansion in the US is coming at the wrong time of the economic cycle. That's because it's adding stimulus in the form of substantial additional government spending when the economy is already at or close to full employment.
That's both inflationary and bad for the sustainability of the country’s deficit. Yet less well recognised is the relationship between this stimulus and one of Trump's other policy fundamentalisms: trade.
The US economy, in my view, is now 'late cycle'. We should be thinking about how the end of the cycle unfolds rather than continuing to talk about recovery. We can see this by the following signs:
- Unemployment is the lowest in 18 years;
- The yield curve is very flat (as the best naive forecaster of the economic cycle it's amazing how often we ignore it);
- Asset prices, perhaps most importantly, have started to treat good news – stronger economic data – as bad news.
These are all classic late-cycle signs. Inflation – another classic sign – is still partly missing in action but that is changing slowly.
'Late cycle' doesn't mean a recession is imminent, or even a realistic probability on any horizon. Thank goodness for that: the average US Federal Reserve interest rate easing cycle during a recession is over four percentage points.
The current Fed funds rate is 1.5 per cent, so even with another 75 basis points worth of hikes this year, it will only finish the year at 2.25 per cent. That means a recession would be extremely challenging to counteract meaningfully with monetary policy.
As the US is late cycle, we can be confident fiscal stimulus won't boost GDP growth in any material fashion. That's because, by definition, a late-cycle economy doesn't have much in the way of spare resources to deploy.
Certainly that is true in the US labour market. Even if the US has spare investment resources, such as steel and cement, a substantial pickup in borrowing will almost certainly be needed to finance that.
That doesn't seem likely at current interest rates given the US government's gross financing task this year is more than 20 per cent of GDP according to the International Monetary Fund. This is larger than Spain, a known fiscal struggler. Crowding out is already occurring.
Rather than showing up in GDP growth, the fiscal stimulus will show up in imports and inflation. Inflation is the market's fear and that is reasonable.
The reality is while oil prices have been helping nudge inflation higher and wage growth has picked up a bit further, technology is still providing an important economy wide deflationary overlay.
This has challenged our understanding of the inflation process which means the outlook for inflation is much more uncertain than it has been previously.
The more-corrosive outcome of this stimulus, however, is the less-explored link between fiscal stimulus and trade.
Trump is adding demand, which can mostly only be satiated by increasing imports. Imports have already been rising – in fact the US trade deficit is now the largest since 2008. Given the impact of stimulus will only start being felt over the next few quarters, a further material deterioration in the US trade deficit over the next year or two seems almost certain.
In some ways this is good news. It can extend both the US and global growth cycles for longer. Despite everyone arguing that a rise in inflation would be good, a sharp rise in US inflation would raise the risks around the longevity of the cycle substantially. With the fed fund rate so low, that could cause serious problems.
Other countries benefiting from stronger exports would also have a false assurance about the strength of their economies. We've seen this before: US consumers support the world, but the growth plane doesn't realise not all the engines are functioning well.
It encourages governments facing politically fractious populations (including in Australia), to chase easy options for driving growth – such as exports, fiscal stimulus or retaining super easy monetary policy – rather than delivering a sustainable improvement in living standards through genuine, and equitably delivered, reform.
But let's consider the politics.
The continued deterioration in the US trade balance is likely to be a surprise to the White House. When the chair of the President's Council of Economic Advisors argues "the beneficiaries of a corporate tax cut tend to be workers, who work at businesses" he may well be right. I hope he is.
But when he adds the fiscal stimulus is keeping jobs at home, one wonders where he is coming from. It's certainly not from well thought-out economics.
Late-cycle doesn't mean end of cycle; thankfully. It does, however, mean credit risks are starting to rise. Against this backdrop, the temperature on trade is already elevated. How much further it rises is likely, as much as anything else, to determine how the remainder of this economic cycle progresses.
Richard Yetsenga is Chief Economist at ANZ