More Tariffs ,More Growth, and More Hikes

The news on job growth in the August employment report was mixed. On the positive side, the payroll gain of 201k beat expectations and we may see a further upward revision to this number in the next report . On the negative side, a cumulative 50k downward revision to prior months has taken the 3- and 6-month averages back down to slightly below 200k for now; also, household employment declined.

But the bigger picture is that US economic growth remains very strong. The sharp rebound in both ISM surveys kept our CAI at 3.7% in August, while our Q3 GDP tracking estimate has edged back up to 3.2%. This implies underlying growth of 3½% at the moment, twice our estimate of the economy’s potential and consistent with a rapid pace of labor market tightening.

Some of this tightening was visible in the jobs report, with slight declines in the unrounded unemployment rate (from 3.87% to 3.85%) and in U6 (from 7.5% to 7.4%). Clearer signals are available in other indicators of labor market slack. In particular, the “jobs plentiful/hard to get” differential in the consumer confidence survey moved up to +30 last month, the strongest on record except for the tail end of the 1990s expansion, and indicators such as job openings and reported skill shortages have moved up further to all-time records over the past several months.

The most market-moving aspect of the jobs report was the 0.37% increase in average hourly earnings, which brought the year-on-year rate to a cycle high of 2.9%. We generally think that markets overstate the significance of any one number—they are quite noisy month-to-month—but it is worth noting that the highest-quality indicators of US wage growth are now all near 3% . This is close to the rate one would expect in a full-employment economy given the still-weak trend in measured productivity growth.

As price inflation has moved up to 2% according to both the PCE excluding food and energy and the Dallas Fed’s trimmed-mean PCE . Our forecast of continued acceleration to 2.3% by the end of 2019 is not particularly problematic in the context of a symmetric 2% target, but it could nevertheless be important for the monetary policy outlook. After all, if we do go higher from here, it will become harder for Fed officials to maintain their emphasis on the lack of inflation pressure as an offset to the overheating in the labor market.

We argued last month that the Fed’s measures of the neutral real funds rate, r*, would likely drift higher over time under our forecast of ongoing hikes in the actual funds rate, solid growth, and gradually rising inflation.The trend in most of them is upward and gradual further gains are likely.

While the risks around NAFTA and the auto sector have diminished somewhat, the Trump administration looks very likely to announce tariffs of up to 25% on imports from China worth $200bn next week, with implementation a few weeks thereafter. If China retaliates, as we expect, a further round of tariffs on the remaining $267bn in US imports would likely ensue .

One reason why the Trump administration has continued to escalate the trade war is that its short-term effects on US growth are not as clearly negative as widely believed. The “primary” impact is to boost the demand for US output by reducing foreign competition, especially if retaliatory moves are less than one-for-one . The “secondary” effects—greater business uncertainty, potentially tighter financial conditions, a hit to supply chains, and non-tariff retaliation—are negative and ultimately probably bigger, but our best estimate remains only a modest net impact.

The inflation effect of higher tariffs is starting to become a bit more important. This is partly because the starting point for core inflation is higher, partly because the incremental amount of goods affected is now much greater than in prior rounds, and partly because the focus is inevitably shifting toward consumer goods. Our best estimate is that the tariffs imposed to date plus the $200bn China round will boost the core PCE index by about 0.1pp; further tariff rounds—including the remaining $267bn in imports from China and the potential auto tariffs—could triple that number in a worst-case scenario.

In general, we remain comfortable with our forecast of six more rate hikes through the end of 2019. Our terminal rate of 3¼%-3½% seems broadly consistent with the Fed’s own view, based on the dot plot, Chairman Powell’s speech in Jackson Hole, and recent Fed staff research on the implications of uncertainty for optimal monetary policy. Although it is certainly possible that trade policy and emerging market spillbacks will result in a shallower path, on net we think the risks are tilted to the upside of our baseline forecast given the impressive growth momentum, the upward trends in wage and price inflation, and the very limited impact of the hikes on financial conditions so far.