Tariffs can be deflationary

Tariffs are generally assumed to have an inflationary effect on the economy. I imagine that’s true in most cases, say a developing country with a newly elected populist government. But is it always true?

In my (still underrated) book on the Great Depression, I explained how the Smoot-Hawley tariff had a deflationary impact on the US economy. Stock and commodity prices fell sharply in April-June 1930, as the bill moved toward passage. The biggest stock market crash of 1930 occurred right after Hoover announced that he would sign the bill.

The same appears to be true of the recent trade war with China, which triggered a narrowing of the 5-year TIPS spread, down .08% to 1.73%:

In both 1930 and today, the Fed could have prevented a contractionary impact by an aggressive easing of policy. But in both cases they were reluctant to ease too rapidly, as that would make their previous rate increases look mistaken. (I’ve discussed this problem in previous posts, which is why I prefer daily rate adjustments, to the nearest basis point.)

I suppose that one could also point to the Fed being reluctant to look like they were being bullied by Trump, although that’s highly speculative.

The Fed funds futures now show one rate cut by year end, and another by mid-2020. That does not mean that money is currently too tight, as rates should move up and down with changes in economic growth. A better argument for money being too tight is that the newest Philly Fed forecast for 2020 inflation has dropped to 1.9%, and I suspect even that’s a bit too high, as market indicators suggest even lower inflation.

That doesn’t mean that everything is gloom and doom; the economy will probably do fine if inflation runs at 1.7% over the next 5 years. But if the Fed is going to have a 2% inflation target, it is better that they actually hit their target—if only to put them further from the zero bound.

Trump is arguing that the Fed needs to cut rates because of the trade war with China. Is Trump correct? The 5-year TIPS spread suggests that a rate cut would indeed be appropriate. But given my severe case of TDS, I’m reluctant to give him any credit. I hope readers won’t be offended if I point out that his argument makes no sense. Trump insists tariffs have an expansionary impact on the US economy. If that actually were the case (it isn’t), then Trump would be wrong in arguing that the trade war provides a rationale for the Fed to cut rates.

Trump is probably of two minds. His primitive understanding of trade theory leads him to view tariffs as expansionary, whereas the strongly negative view of stock investors toward tariff news triggers fear in the reptilian part of his brain. (And really, is there any other part?) And that fear leads him to call for the Fed to assist him in the trade war.

PS. Slightly off topic, but this David Beckworth tweet gets to the heart of the problem with monetary policy:

Here is my real critique: the Fed can get all the new tools in the world–neg rates, yield curve control, auto QE, etc.–but with a low inflation target regime they probably won’t matter much. IMHO, the past decade has shown us it is the monetary regime not the tools that is key.

I worry that the profession is focused too heavily on technical gimmicks, and is missing the bigger picture.

Does Trump actually want lower rates?

Oh, I know that Trump wants the Fed to cut its target rate ASAP. But that’s not my question. My question is whether Trump actually wants lower interest rates over an extended period of time.

Here’s Yahoo:

Well, President Donald Trump got his interest rate cut… sorta.

Trump warned on Twitter over the weekend that tariffs on $200 billion in Chinese goods could rise to 25% on Friday. He added that a 25% tariff will soon be assigned to a selection of $325 billion in presently untaxed goods.

The proclamation uprooted the latest push higher in stocks globally, with the bellwether Dow Jones Industrial Average losing more than 400 points early on in Monday’s session. But, the yield on the 10-year Treasury note dropped to 2.48% as investors flocked to the government-backed safe-haven. . . .

So, in effect, with a series of tweets the president managed to make it cheaper — at least for the short-term — to take out a mortgage or buy stuff on variable rate credit cards. . . .

“He got what he wanted on rates,” AGF Investments Chief U.S. Policy Strategist Greg Valliere told Yahoo Finance Monday.

Trump has made his views on Federal Reserve Chair Jerome Powell no secret.

Actually, Trump has made his preferences a secret. Trump has never told anyone how he would like the rate cut to be accomplished. He hasn’t told us whether he’d prefer a brief rate cut, followed with considerably higher interest rates over time, or whether he’d prefer a policy that cut interest rates over an extended period of time. The former involves easy money and the latter involves tight money.

In other words, Trump hasn’t told us whether he’s a low rate guy who favors slow NGDP growth, or whether he’s a high rates guy who favors fast NGDP growth.

You may think you know what he wants, but he’s never told us.

In any case, Yahoo is right. Trump’s recent actions did result in an interest rate cut. All of you who insisted that “Trump was right about the need to cut rates” can now bask in your “success”.

Why fly?

I hate flying. There’s driving to the airport, then looking for a parking space, then airport security, (some tickets even require you to get a boarding pass at the airport), then waiting in a slow moving line to board the plane, then sitting in a tiny seat for 20 minutes before the plane actually takes off, then a bumpy ride, then waiting a long time to get off the plane. You might even have been forced to put your carry on bag in the luggage section at the last minute, requiring you to wait at baggage claim.  

I love trains. They are smooth and spacious and comfortable, at least if you live outside the US.  So will someone explain the following to me:

Moritz Leiner, a representative of the Association of Ethical Shareholders Germany, urged Lufthansa to reconsider its climate-change policy, pointing out that the company operates four daily flights from Munich to Nuremberg, two cities that are only a two-hour drive apart.

The driving time seems like an odd comparison, so I goggled some train data for Munich to Nuremberg:








So there are 55 trains a day, with an average time of 1:20 and the fastest at 1:02. I understand why people fly when the cities are far apart. But why do people take short flights? Can someone explain what I’m missing? It seems like low hanging fruit for the fight against global warming. And I’m not even a fan of high speed rail boondoggles in places like California. But what about where you already have decent train service? Why fly?

PS. I’m usually sitting around row 37. Sometimes I wonder what would happen if every passenger in front of me was a Navy Seal. How long would it take them to stand up, grab their carry-on and walk off the &$#*@&$ plane. The actual humanity in front of me takes forever, exhibiting an especially annoying mix of selfishness and clumsiness.

Fracking drives manufacturing

[Before starting, let me recommend a new Sebastian Edwards paper discussing the effectiveness of MMT-style policies in Latin America. I have a new post at Econlog.]

Last year, I did a post over at Econlog speculating that cycles in the price of oil led to cycles in fracking activity, which led to cycles in manufacturing employment growth.

Seven months later, the fracking/manufacturing part of the hypothesis is looking increasingly plausible. For various reasons, fracking activity has slowed in recent months. In this case, however, the slowdown is not due to weak oil prices, and experts predict a pickup later in the year:

Schlumberger CEO Paul Kibsgaard told analysts and investors last week that his company is seeing a slowing-down of activity in the U.S. shale plays over the first four months of 2019. “North America land activity is set for lower investments with a likely downward adjustment to the current production growth outlook,” Kibsgaard said, “the higher cost of capital, lower borrowing capacity and investors looking for increased returns suggest that future E&P investments will likely be at levels dictated by free cash flow. We, therefore, see land E&P investment in North America down 10% in 2019. ”

Overall, employment growth in 2019 continues to be strong, running at 205,000/month, only slightly below 2018 boom levels.  But manufacturing job growth is slowing more rapidly, with growth especially anemic over the past three months.  Year-over-year data shows the rate of manufacturing job growth slowing from a peak of 2.3% in July 2018 to 1.6%, and I expect a further decline.

Notice that there was also a manufacturing jobs boom during the 2014 fracking boom. 

Labor force participation in April was 62.8%, exactly the same as 5 years ago.  But that’s actually good news, as the retirement of boomers was expected to lead to further declines.  On the other hand, I doubt we’ll get back to the levels of the late 1990s; there are too many demographic headwinds:

The 3.6% unemployment rate is consistent with what we are seeing in other similar developed economies. Relatively “neoliberal” economies are seeing unemployment fall to rates not seen since the 1960s. What makes the US stand out is that productivity numbers have also been pretty good (unlike places like the UK.)

Job growth in the US is also helped by a recent surge in immigration. Overall, a very good jobs report. It shows that manufacturing is not the key to strong employment gains, but fracking is the key to strong manufacturing jobs gains.

PS. Speaking of the UK, I predict their next election will feature Trump vs. Sanders, err, I mean Boris Johnson vs. Jeremy Corbyn. If the Liberal Democrats can’t do well against those two clowns, it’s time to close up shop. If the Brits had any sense, they’d make Rory Stewart their PM. But only after Brexit is resolved—that’s one of those problems that would destroy any leader.

Inching toward NGDP targeting

An increasing number of important people recognize that NGDP level targeting is superior to inflation targeting. Nonetheless, the Fed is unlikely to suddenly switch to NGDP targeting. Rather, the change will occur gradually over time, in stages.

Let’s think about a policy of price level targeting. In what situations would that move us closer to NGDP level targeting, and when would it be inappropriate?

1. Suppose a supply shock suddenly hits the economy, such as a surge in imported oil prices caused by a shutoff of oil from an important exporter. This shock might push inflation higher and output lower. The effect on NGDP would be small.

If the Fed were targeting the price level, and the oil shock pushed inflation up to 4%, then they would be required to aim for 0% inflation next year, or 1% inflation over the next two years.

But if the oil shock has little or no impact on NGDP, that reversion to the price level trend line would actually be inappropriate. So price level targeting does not do well when there is a supply shock to the economy.

2. Suppose a demand shock suddenly pushes inflation much higher or much lower. In that case, NGDP will also rise or fall relative to trend, indeed by even more than inflation. Now a reversion back to the trend line would be appropriate. If the economy temporarily overheats, then profits will initially rise sharply. Wages are sticky and don’t move much in the short run. Bringing prices down will help to push profits back down to a more normal level, and insure macroeconomic stability.

An even more important example occurs when there is a sudden fall in inflation due to a negative demand shock. In this case, it helps to run inflation at levels above normal in a catch-up period, as this will also help to restore NGDP to its trend line and shorten the recession. A negative demand shock is perhaps the clearest case where price level targeting helps to stabilize the economy by mimicking the effects of NGDP level targeting.

When Ben Bernanke recently proposed a modified form of price level targeting, he suggested that whenever the economy falls to the zero bound during a recession, the Fed should commit to price level targeting until the previous trend line is restored. Note that recessions that push interest rates to zero are almost always caused by negative demand shocks.

Why is this important? Because Bernanke’s proposal is the single most likely outcome of the Fed’s June conference to re-evaluate its policy strategy. It is also the form of price level targeting that most closely approximates the best aspects of NGDP targeting. It is a policy that implicitly says we should not always do price level targeting, rather do it when it would be most likely to produce NGDP level targeting-like results.

The market part of market monetarism will also happen in stages. The Fed is already paying more and more attention to market indicators and less to Phillips Curve-based models of inflation (which haven’t worked.) Next step is to change the fed funds target daily, in increments of 1/100%, with up and down moves equally likely. That’s how markets behave. An NGDP futures market guardrail is still a few decades away.

In their heart, Fed officials must know by now that NGDP targeting would have been better than inflation targeting. But we will get there in baby steps, which is probably how it should be. Monetary policy is too important to make a sudden lurch into the unknown.