The Price of Greatness

The Fed’s dual mandate of full employment and moderate inflation will face challenges this year. Goods inflation will exacerbate the persistent rise in housing costs as tariffs disrupt global trade. The Federal Reserve will face the challenge of managing a slowing economy and declining employment. Headline growth may appear stronger than underlying economic conditions, as an improving trade deficit masks weakening exports and consumer demand. Nevertheless, rising unemployment will pressure the Fed to cut interest rates, even as inflation remains above target. This move could reignite housing price increases and fuel further inflation. With monetary policy having limited influence over employment losses driven by trade wars, the risk of stagflation will loom large. The Fed will need politicians to reverse the economic turmoil of their own making.

Monetary policy is ostensibly slowing the economy, while politics is initiating a trade war and heightening economic uncertainty. Either would conspire with monetary policy to deliver lower growth. Together, they may deliver stagflation or worse. There is a price for greatness.

A Turning point. While the economy continues to grow, the impact of high interest rates is beginning to show (Exhibit 1). Investment declined for the first time in four years. The worrisome sign is that the decline was broad-based: all sub-categories declined except structures (both private and residential), which were only modestly positive. Indeed, high interest rates impair investment to some degree, and an investment slowdown in artificial intelligence further magnifies the impact. While an investment retrenchment preceded every recession in the last seventy years, many investment slowdowns have not resulted in a recession. It is only when other sectors are falling simultaneously that a recession is foretold.

Exhibit 1. GDP Contribution by Component

Source: Federal Reserve Economic Database, CRM Calculations.

The Fed’s challenge is to achieve a soft landing of the economy, where policy loosens before employment declines. Unequivocally, investment is slowing. The trouble is that monetary policy is only loosely linked to consumption. Indeed, higher financing costs reduce the marginal borrower, yet housing real estate investment continues apace. The Fed’s concern is how inflation limits consumer spending and impacts employment. When consumer spending changes, the Fed’s policy must change. The critical indicator is goods consumption, whether domestic or imported.

Inflating Behavior. The pandemic inflation surge is moderating, yet core inflation remains at 30-year highs (Exhibit 2). The prolonged inflation initiates a change in consumer behavior through the substitution effect. As a particular good increases in price (e.g., beef), the consumer substitutes that good with another lower-cost good (e.g., chicken). If inflation is short-lived, consumer behavior does not change permanently, and they will revert to the prior good once inflation moderates. The challenge is that when inflation persists, behavior change may endure.

Exhibit 2. Consumer Price Index (CPI) and CPI ex Food & Energy (Annual Change, %)

Source: U.S. Bureau of Labor Statistics, retrieved from FRED, Federal Reserve Bank of St. Louis.

Inflation will likely return to the two percent threshold in a year at the current deceleration rate. This outcome would deliver five years of above-target inflation, which could cause a permanent shift in consumer behavior. Yet, this inflation period would be three years shorter than from 1991 to 1998, when core inflation slowly declined from nearly six percent to two percent. The critical dimension is that consumption buckets changed over the last thirty years, and crucially, their contribution to GDP. Housing is a material contributor to core inflation, which monetary policy can indirectly influence; however, there is little impact on goods or services, which is a concern.

Consumer Change. It is said that the only constant is change. This maxim, however, was not always the case for the major product categories for GDP. From 1950 to 1980, the economy's proportion of goods, services, and structures was relatively constant (Exhibit 3). In the mid-1980s, goods started to account for a more significant proportion of the economy, taking off in the early 2000s. Interestingly, the gain in goods came entirely from a decline in structures. The economy shifted from producing long-lived assets like real estate to shorter-term durable and consumer goods, even as the economy doubled in size. This change has implications for both monetary and foreign policy.

Exhibit 3. GDP by Major Product Type

Source: U.S. Bureau of Economic Analysis, retrieved from FRED, Federal Reserve Bank of St. Louis.

Monetary policy can influence the cost of financing, particularly for long-lived assets usually financed with debt. However, this is not the case for goods tied less to monetary policy and more to consumer well-being, both domestically and internationally. The key driver is usually employment; however, another critical driver is international trade, which the past 40 years of change in GDP composition highlight. As trade barriers fell, the US consumer enjoyed cheaper and higher-quality goods while their products were exported to foreign markets — comparative advantage writ large.

Declining Government. In the 1980s and 1990s, America led the neoliberal free trade dictum. Its economy followed suit with trade deficits expanding. Yet the dramatic increase in the trade deficit post-2000 was primarily due to China’s entry into the World Trade Organization (WTO) (Exhibit 4). This resulted in two further outcomes for GDP proportions: consumption increased while government expenditure decreased. The US could consume more as trade liberalization delivered a bonanza of cheaper tradeable goods.

Exhibit 4. GDP Contribution by Sector

Source: Bureau of Economic Analysis. Retrieved from FRED, Federal Reserve Bank of St. Louis.

A trade deficit, however, requires balance in national accounting. As the US consumer provides their currency to pay for the imports, the seller must do something with the money. The seller may either repatriate the funds to their currency or keep it in US dollars. In the latter case, they then invest in the US capital markets. This outcome is evident in the change of investment from 2000 to current: the two percent decline in net exports is wholly offset by a two percent increase in Investment.[1] Trade enabled more consumption in the US, highlighting the central tenet of free trade: comparative advantage.

Employment Evolution. Over the past fifty years, the US employment landscape has evolved from a scenario where global market jobs comprised approximately a quarter of employment to one in which only one in ten workers faces global competition (Exhibit 5).[2] This outcome reflects the diminishing contribution of exports to total gross domestic product (GDP) during a similar timeframe. This observation underscores a vital strategic rationale for trade barriers: the domestic employment market may not be directly vulnerable to a trade war.

Exhibit 5. Employment Share by Domestic vs Global.

Source: U.S. Bureau of Labor Statistics, retrieved from FRED, Federal Reserve Bank of St. Louis. Global sectors include mining, manufacturing, and information technology.

This conclusion, however, creates a fallacy of composition. While employment sensitivity to global markets may have less impact on domestic employment, trade wars affect a country’s exports and imports. This outcome is the central tenet of comparative advantage: produce where you possess an efficiency advantage and import everything else. The critical dimension of the argument involves substitute products and switching costs.

Exporting Excellence. America is a world leader in technology and advanced manufacturing. Naturally, its exports reflect this outcome (Exhibit 6). Capital and industrial goods are its largest export sectors, each accounting for one-third of the total. The threat is whether there are substitutes for these products. This is the first concern: about 40% of the industrial category is petroleum products with minimal switching costs. Further, semiconductors, telecom, and electric appliances lead the capital goods category. While these latter products have high switching costs, substitutions do exist. Critically, these sectors are more straightforward to focus upon for targeted responses.

Exhibit 6. Export Value by Sector ($ Billions)

Source: U.S. Bureau of Economic Analysis, retrieved from FRED, Federal Reserve Bank of St. Louis.

 Business services are a significant export component, yet fungible on the world market. While food is a strategic resource, there are close substitutes on the global market. These varying categories highlight the challenge for America in a trade war: there are either substitute products or low switching costs for their material exports. While the lower relative employment in these sectors makes the impact less burdensome, it does enable American trade competitors to make targeted countermeasures that are less impactful to them. Precision may trump power in this instance.

Import Importance. Imports are about a third larger than exports and led by Capital and Consumer goods (Exhibit 7). The American trade deficit is primarily a function of these two categories. In contrast, services and industrial goods run at a surplus, highlighting the risk of a trade war. The degree of price sensitivity and substitute products for consumer goods will determine the degree of effectiveness of tariffs. The trouble is that there are no close domestic substitutes after decades of outsourcing.

Exhibit 7. Import Value by Sector ($ Billions)

Source: U.S. Federal Reserve Board, retrieved from FRED, Federal Reserve Bank of St. Louis.

The critical issue, however, is capital goods without close substitutes. Tariffs will increase prices with no corresponding productivity increase. The tariff increase will act as a direct tax on consumption because substitute products are unavailable. Yet, the rest of the world enjoys alternative sources for its imports (i.e., US Exports). The result is that imports could increase at the tariff rate (e.g., 25%) while exports decline as counter-tariffs are imposed that reduce the competitiveness of US exports. The unfortunate outcome in this scenario would be that the net export deficit expands. Strategic substitutes may counteract tactical tariffs, impoverishing the US consumer.

Taxing Consumption. A credible argument exists for taxing consumption through tariffs or a national sales tax. The latter is preferred for two reasons: the precision at which it can target specific consumption baskets and the perception that it is not directly targeting trade, thus limiting the competitor's strategic response. In contrast, a trade war led by tariffs invites retaliatory tariffs because of the composition of US exports and imports.

[1] This simplifies national accounting yet is intended to highlight the required balance.

[2] In this accounting, mining, manufacturing, and information technology are global tradeable goods; all other sectors are domestic-focused, i.e., location-based.

This excerpt is from the US Economic Outlook 24Q4. Read more here.