The first step in solving a problem is figuring out what is causing it. Too often we get so focused on the symptoms that we forget to treat the disease. The market – which has had a fantastic year – is having a tough few days. There are two competing causes: trade and Fed policy. So, which is it?
Last week we had our GDP report. Growth was good at 2.1 percent, but not as good as it has been. When one lifted up the hood to see what led to 2.1 percent growth, he learned that personal consumption (consumers) was up 4.3 percent, while net exports were down 5.2 percent, and business investment was down 5.5 percent. Granted this is still better growth then we have seen for some time in the U.S., but it is beginning to be clear what is good policy and what is bad policy.
Tax and regulatory reform have helped create the best job market in my lifetime and robust consumer growth, which are now being almost fully offset by the damage of tariffs. I have said it before, but it bears repeating: administration officials have maintained that tariffs are a negotiating tactic and not a long-term policy. So maybe this works with the Chinese or maybe it doesn’t. In the meantime, real damage is being done to our economy by the tariffs.
The biggest challenge is not even the tariffs themselves, but the psychological effect of the tariffs on business decision-makers. If one is trying to determine where to put a factory, or whether to build it in the first place, she has to hesitate. She doesn’t know what the rules will be because they seemingly change with a tweet. This seems to be the logical cause for the sudden slowdown in business investment.
This brings us to the Fed. Jerome Powell has been unfairly beaten up by the idea that Fed policy is what is driving the slowdown in growth. The idea of interest rates being too high is that the cost of borrowing money to build that factory is too great. If the loan payments eat up any potential profit, then the factory will not be built.
It is possible that the 2.5 percent Fed funds rate (before the cut) was so high as to stop a business project, but it isn’t likely. Cutting it to 2.25 percent, as was done earlier this week, is not very likely to make or break a decision. One would be a pretty poor business person if he was relying on 0.25 percent savings on interest to make a project profitable.
The rules of trade outweigh loan costs by a large margin. Negotiating is ugly, and the Chinese are tough negotiators. China’s Xi is in office for life and Trump has either one or five more years depending on an election. This gives Xi a huge advantage at the negotiating table.
In the meantime, the Fed is in an undesirable position. Their primary weapon, lowering interest rates, is not likely to make a difference to the business manager who is waiting for trade rules to settle before making a move. We could end up like Japan, where negative interest rates have failed for years to boost the economy. Meanwhile, there are other effects of low rates that can be damaging in the long term. This is a tough place to be, and I suspect they will be very cautious in their moves. The administration and short-term traders won’t like that, but it is probably the wisest policy.
Trade is the real culprit. Perhaps the tariff tactics will work and we can get past this quickly and have a better trading environment as a result; that would be great, and we should all be pulling for that outcome. The question is, when will we know that this isn’t working, and what do we do then? I don’t know the answer, but I do know that beating up on Jerome Powell is not it.
Chuck Osborne, CFA