Well, it sure looks like we are heading towards a full-blown trade war. While this would lead to a severe reduction in global GDP, maybe a decline of up to 2 percentage points in the medium run, I don't think it would lead to a global recession. However, given the international nature of global supply chains, a trade war could lead to massive disruptions and enormous job losses in the short-run. Frankly, I am surprised that equity markets have held up so well in recent weeks. Maybe they still think that a trade war will be averted and that the Trump administration will in the end come to its senses. What is this belief based on though? Everybody should be aware now that this is the most incompetent, ignorant, malevolant, and outright racist group of people that have ever ruled America.
Given that a trade war is a negative supply shock, leading to employment losses and higher prices, there is also not much the Fed can do to reduce the amount of pain as lowering interest rates would only increase the inflationary pressures that trade barriers are creating.
While the upcoming trade war is certainly of great concern, there is the additional worry of the flattening yield curve, which usually is an omen of an upcoming recession.
While the Fed has been starting its tightening cycle over the last couple of years, hiking short-term interest rates from zero in 2015 to now 2%, interest rates at the long-end have barely moved upwards. Some economists, like Larry Summers, have suggested that we have entered a new macroeconomic regime in the aftermath of the financial crisis, also known as secular stagnation. Some factors, including unfavorable demographics, low productivity growth (No, the robots are not coming for your job!), and rising inequality, have put significant downward pressure on the natural rate of interest. Remember that the natural rate is the interest rate that is consistent with a stable rate of inflation and full employment.
Some estimates suggest that the "new normal" is a natural rate of maybe 2 to 3% (in nominal terms) for the US economy, whereas it is even lower in Europe and Japan, which has basically experienced zero interest rates for almost three decades now.
If the new natural rate of interest is significantly lower than before the crisis, then the Fed has not a lot of room left in the current tightening cycle. While Fed officials have suggested that there might be maybe one or two rate hikes to come this year, it sure looks like this would be a massive mistake.
The graph below shows the difference between the yields on 2-year US Treasuries and 10-year Treasuries, essentially the slope of the yield curve. A negative sloping yield curve, meaning that rates on short-term bonds are higher than long-term bonds, is the best and one of the most accurate recession predictors. Every time this has happened, a recession has followed, usually with a time lag of about one year. Why is that? Well, higher short-term rates usually indicate that the Fed has tightened monetary policy too much, given the fundamentals of the economy. One should bear in mind the famous phrase by Rudi Dornbusch: "Expansions don't die of old age, every single one of them was murdered by the Federal Reserve."
While this is very harsh, there is certainly a lot of truth in it. Most recessions in the modern economy are fundamentally originating on the demand side. Insofar as the Fed is responsible for aggregate demand management, they are ultimately as well responsible for keeping the business cycle in check. It is the Fed that determines the rate of inflation, the rate of NGDP growth, and the pace of job creation while the government has much less control over any of those variables than what is commonly assumed.
The recent job report also shows that the Fed actually has tightened too rapidly in recent years as even 10 years after the financial crisis the US economy might still be somewhat below full employment. While the unemployment rate has reached a historic low of 3.8% recently, it actually edged up back to 4% over the last month. This, however, is good news. The US economy is still creating about 200.000 jobs a month, which is still far above the level that some economists have suggested is consistent with demographics in the long-run (about 100.000 jobs). The recent uptick in the unemployment rate was entirely due to more people joining the labor force as the labor market is finally picking up some steam. Over the last year, even some marginalized workers have joined the labor market, including workers with a criminal record, and the unemployment rate for minorities has been on a downward trend for years as well: The gap between the white and the black unemployment rate, for example, is also on a historic low. All of this is obviously great news. However, it also means that if Fed officials had not started their tightening cycle about 3 to 4 years ago, some of these gains could have materialized much earlier, growth could have been higher, and some of the employment gains could have occurred years ago. Furthermore, the big fear now is that the Fed is choking off the US economy by hiking the short-term interest rate by more than what is warranted. The yield curve will surely invert by the end of this year if they proceed with their two projected rate hikes. Don't believe any claims that the flattening of the yield curve is no reason to worry about because some factors are putting downward pressure on long-term bond yields (such as the Fed's large balance sheet as well as high international and domestic demand for safe assets). Every time someone is claiming that this time is different, it really isn't!!!
PS: According to Paul Krugman, this is the dumbest trade war. No, trade wars are not easy to win and the Trump administration lacks a coherent strategy. What a surprise. Instead of putting tariffs on final goods, the US government decided to put tariffs on a lot of intermediate goods, that are used in production processes downstream, meaning that a lot of US companies will ultimately suffer as they will face higher costs. The retaliation by China and other countries, on the other hand, has been much smarter. Tariffs on soy beans and other agricultural products will mostly hurt the regions in the US that have helped elect the Trump administration.
https://www.nytimes.com/2018/07/07/opinion/how-to-lose-a-trade-war.html
Given that a trade war is a negative supply shock, leading to employment losses and higher prices, there is also not much the Fed can do to reduce the amount of pain as lowering interest rates would only increase the inflationary pressures that trade barriers are creating.
While the upcoming trade war is certainly of great concern, there is the additional worry of the flattening yield curve, which usually is an omen of an upcoming recession.
While the Fed has been starting its tightening cycle over the last couple of years, hiking short-term interest rates from zero in 2015 to now 2%, interest rates at the long-end have barely moved upwards. Some economists, like Larry Summers, have suggested that we have entered a new macroeconomic regime in the aftermath of the financial crisis, also known as secular stagnation. Some factors, including unfavorable demographics, low productivity growth (No, the robots are not coming for your job!), and rising inequality, have put significant downward pressure on the natural rate of interest. Remember that the natural rate is the interest rate that is consistent with a stable rate of inflation and full employment.
Some estimates suggest that the "new normal" is a natural rate of maybe 2 to 3% (in nominal terms) for the US economy, whereas it is even lower in Europe and Japan, which has basically experienced zero interest rates for almost three decades now.
If the new natural rate of interest is significantly lower than before the crisis, then the Fed has not a lot of room left in the current tightening cycle. While Fed officials have suggested that there might be maybe one or two rate hikes to come this year, it sure looks like this would be a massive mistake.
The graph below shows the difference between the yields on 2-year US Treasuries and 10-year Treasuries, essentially the slope of the yield curve. A negative sloping yield curve, meaning that rates on short-term bonds are higher than long-term bonds, is the best and one of the most accurate recession predictors. Every time this has happened, a recession has followed, usually with a time lag of about one year. Why is that? Well, higher short-term rates usually indicate that the Fed has tightened monetary policy too much, given the fundamentals of the economy. One should bear in mind the famous phrase by Rudi Dornbusch: "Expansions don't die of old age, every single one of them was murdered by the Federal Reserve."
While this is very harsh, there is certainly a lot of truth in it. Most recessions in the modern economy are fundamentally originating on the demand side. Insofar as the Fed is responsible for aggregate demand management, they are ultimately as well responsible for keeping the business cycle in check. It is the Fed that determines the rate of inflation, the rate of NGDP growth, and the pace of job creation while the government has much less control over any of those variables than what is commonly assumed.
The recent job report also shows that the Fed actually has tightened too rapidly in recent years as even 10 years after the financial crisis the US economy might still be somewhat below full employment. While the unemployment rate has reached a historic low of 3.8% recently, it actually edged up back to 4% over the last month. This, however, is good news. The US economy is still creating about 200.000 jobs a month, which is still far above the level that some economists have suggested is consistent with demographics in the long-run (about 100.000 jobs). The recent uptick in the unemployment rate was entirely due to more people joining the labor force as the labor market is finally picking up some steam. Over the last year, even some marginalized workers have joined the labor market, including workers with a criminal record, and the unemployment rate for minorities has been on a downward trend for years as well: The gap between the white and the black unemployment rate, for example, is also on a historic low. All of this is obviously great news. However, it also means that if Fed officials had not started their tightening cycle about 3 to 4 years ago, some of these gains could have materialized much earlier, growth could have been higher, and some of the employment gains could have occurred years ago. Furthermore, the big fear now is that the Fed is choking off the US economy by hiking the short-term interest rate by more than what is warranted. The yield curve will surely invert by the end of this year if they proceed with their two projected rate hikes. Don't believe any claims that the flattening of the yield curve is no reason to worry about because some factors are putting downward pressure on long-term bond yields (such as the Fed's large balance sheet as well as high international and domestic demand for safe assets). Every time someone is claiming that this time is different, it really isn't!!!
PS: According to Paul Krugman, this is the dumbest trade war. No, trade wars are not easy to win and the Trump administration lacks a coherent strategy. What a surprise. Instead of putting tariffs on final goods, the US government decided to put tariffs on a lot of intermediate goods, that are used in production processes downstream, meaning that a lot of US companies will ultimately suffer as they will face higher costs. The retaliation by China and other countries, on the other hand, has been much smarter. Tariffs on soy beans and other agricultural products will mostly hurt the regions in the US that have helped elect the Trump administration.
https://www.nytimes.com/2018/07/07/opinion/how-to-lose-a-trade-war.html
The S&P 500 and global stock markets in general have not declined as much as expected, given that we are heading towards a full-blown trade war
The flattening of the US yield curve, potentially a sign of a looming recession
