The U.S. economic expansion is now the second-longest in the post-WWII era. The economy is growing at an above-trend pace and the unemployment rate has not been this low since the late 1960s. All of these factors are elevating the resilience of the economy, but ironically this strength may be creating a vulnerability of its own accord. Robust growth may mask early cracks emanating from tariffs; it may also give the Trump administration the confidence to charge more boldly into a large-scale trade war.
SOLID GROWTH PATH
The U.S. economy is on a solid path heading into the second half of 2018. Growth was already poised to make a strong showing this year due to tightening labor conditions supporting firmer consumer spending and business capacity expansion. Tax reforms are pushing growth to an even faster pace. Fiscal tailwinds could drive 2018 real GDP growth to the quickest pace of any year in the current cycle and should, at the very least, provide a buffer offsetting some of the headwinds from escalating trade tensions.
For the second half of 2018, we expect the main GDP contributions to be similar to the profile over the past year. Consumer spending, fueled by wage gains and tax cuts, will be the primary driver; business investment will contribute to an increasing degree, but will remain secondary to consumers.
The Federal Reserve is responding cautiously to accelerating growth. This is to avoid creating excessively restrictive financial conditions and to avert choking off potential benefits from tax reforms. Therefore, with both monetary and fiscal policy supporting faster growth, the biggest downside risk to the economic outlook is a full-blown trade war.
RISK OF TRADE TENSIONS
Tariff measures to date are likely to impact GDP growth by about one-tenth of a percentage point (based on Bloomberg consensus), which will hardly be noticeable as the economy approaches 3% growth. However, as trade partners attempt to maximize the impact of their counter-measures, or if tariffs spread to a much broader spectrum of goods, as the latest rhetoric threatens, a retrenchment of economic optimism could have a multiplicative effect.
Fed chair Powell recently warned of rising trade concerns coming from business leaders. He acknowledged that negative fallout had not yet manifested in reported economic data, but said that the Fed’s business contacts were starting to discuss the postponement of hiring, investment and other decisions.
RISK OF FED
Another uncertainty stems from the monetary policy itself. Fed officials are not only unsure of how the economy’s response to higher interest rates has changed in the current cycle, given the long and variable lags prevalent to monetary policy, but there is also uncertainty regarding how an accelerating Fed balance-sheet unwind (the reversal of QE) will impact financial and economic conditions.
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