Wednesday, November 1, 2017

Who will be the next Fed chair?

On the campaign trail, now President Donald Trump made it pretty clear that he wanted Janet Yellen gone as the Chairperson of the Federal Reserve.  Now in a televised speech on Instagram last week (see here), President Trump offered the biggest clue to his intentions by dropping in the word "hopefully" in his wish that "they will do a fantastic job".  That "hopefully" is, in my view, a definite hint that change is on the way, as if he really had another Yellen term in mind he wouldn't have needed that "hopefully" word. As in so many areas with President Trump, he will break precedence if he doesn't reappoint Chairwoman Yellen, as every Fed chair in modern history who has completed a first term has been nominated for a second term.

So now that I believe it is fairly clear that he has signaled that he will replace her, the media has been looking at the candidates that the President has in mind, and focusing on the daily rumors that appear to emanate from the White House about who is in favor.  But the decision is not as easy as you might think, and for two reasons: i) the President has economic growth objectives that many conservative central bankers might see as unlikely and therefore may try and be more hawkish on monetary policy than otherwise would be the case; and ii) the end of the business cycle expansion is approaching, so the President would likely not want a Fed Chair that is inexperienced in the art of central banking.

This is probably the most important appointment that the President will make in his current term of office, as the likelihood of an economic downturn is extremely high, given that we are coming towards the end of the expansionary phase of the business cycle.  Whoever the next Fed chair is will very likely have to cope with a recession, and will have to position the Fed accordingly.

Therefore, in my view, given that Yellen has effectively dropped out of the race, there are really only 3 candidates left in the running. I will deal with each one separately below:

i) Jerome Powell.  Powell is currently on the Fed Board of Governors, so is no stranger to the Fed.  He was appointed to the Board in 2012 and is a card-carrying Republican as well as a multimillionaire having worked at the Carlyle Group.  He is moderate when it comes to monetary policy views but is not an economist, which may be seen by some as a weakness.  Nevertheless he clearly understands monetary policy well, but may not be the right guy for the job if the economy has another severe recession in the next 4 years.

ii) Kevin Warsh.  Warsh was first appointed an economic advisor at the White House in 2002, and then from 2006 to 2011 Warsh served as a Fed governor, but then resigned to join the Hoover Institution where he is currently employed.  He has been a frequent critic of the Fed, and there are already a website that has been established to lobby against his appointment (see here).  He is definitely seen as more of a hawk, and the consensus is that monetary policy would likely be on a tighter trajectory. He was trained as an economist, so that is a plus, but on the other hand many of his predictions when he was previously employed at the Fed (such as higher inflation if the Fed maintained QE) have not transpired, which doesn't give the markets much confidence in his judgment.

iii) Professor John Taylor, is the only distinguished economics professor among the  candidates. He is the author of the so-called "Taylor rule" which was an effort to use a rule-based setting of monetary policy for modelling purposes.  Taylor was at the US Treasury during the George W. Bush administration and served at the White House under Presidents Carter and Ford.  Through his comments on the maintenance of QE, the markets view him as somewhat hawkish, and the media believes that a Taylor appointment would "spook" the markets.

So what is the perception of the odds for each of these candidates?  The website "Predictit" (see here), has odds based on actual bets, and as of Nov 1st at 11.30am, the odds currently are:

So what is my assessment?  For me this comes in 3 parts - i) who will Trump choose and ii) who would be the best choice in my assessment; and iii) who would actually be best for stockmarket gains?  Let's deal with each in turn.

First, who do I think Trump will choose?  It seems that the President has changed his mind almost daily, so although the latest anonymous leak from the White House stating that Powell is the favorite (see here), I doubt this will be sustained until the announcement.  My belief is that Trump will want to go with an economist and someone who will shake things up at the Fed, as he will want to please his base and also impress other Republicans on Capitol Hill.  So my guess is that Trump will go with Taylor as long as he has Taylor's assurances that he will not enact a rules based policy as this would tend to raise rates faster than would be the case with the other candidates and might then derail the so-called "Trump rally" and spook the markets.  Of course if a Taylor appointment is made, then the markets might still be temporarily spooked until they can get reassurance during the Senate confirmation process.

Second, who do I think would be the best choice for the top job at the Fed?  I believe that continuity is important here, and that likely another Yellen term would actually be best for the country as a whole, as Yellen is already acting on "normalizing" Fed policy, but is doing so at a cautious rate that allows for economic growth to be sustained going forward.

Third, who would be the best choice for the markets?  I think the markets, as the polls show, would prefer Powell, as he possesses the element of continuity, but at the same time is a little more "light touch" on financial regulation than Yellen.

What is almost certain though is that whoever takes over at the Fed (unless it is a Yellen reappointment) will change Fed policy going forward, and that will undoubtedly impact the bond markets and perhaps the pace of interest rate hikes and the withdrawal of the QE stimulus, with its attendant effects on economic growth.  

Monday, August 21, 2017

Are "Trump Trade Wars" Inevitable?

President Donald Trump, at his joint address to Congress on February 28th 2017 stated: “I believe strongly in free trade, but it also has to be fair trade. It’s been a long time since we had fair trade. The first Republican president, Abraham Lincoln, warned that the abandonment of the protective policy of the American government would create want and ruin in the country… It’s time we heeded his advice and his ways.”
Free trade has been at the cornerstone of capitalist democratic economies now for many years, so this statement from the President of the biggest trading country in the world looks to President Lincoln to justify a return to protectionism and a reversal of the trend to ever freer trade that has been characterized by the post World War II international economic consensus. This has economists somewhat aghast at what is going on with the Trump administration, as after the new President immediately withdrew from the progressive Trans-Pacific Partnership (TPP) agreement, we also know that the Trump administration is now looking to not only renegotiate NAFTA but also has explored the idea of perhaps bypassing World Trade Organization (WTO) rules so as to impose a border adjustment tax (we'll come to what that is below).

So how will this all play out? Well there is already a battle inside the administration about how protectionist the policy pronouncements will be (see here), and it looks like the battle between the two factions will continue for a while yet, despite the fact that Steve Bannon has left the White House staff. In a recent NYT article (see here) there is doubt that President Trump will be able (or want) to follow through on his campaign promises with as much gusto as he suggested he would on the campaign trail. And in an article in the FT (see here) there were signs emerging that the Beijing relationship has now becoming badly frayed as the Trump administration initiates several unfair trade practices investigations. The danger though here is that the "soft-liners", although they might win in the short run, will not hold the upper hand as we approach the mid-term elections in late 2018 and beyond, as the administration realizes they are being punished at the ballot box for not fulfilling on these commitments.
So let's take stock of where we are in terms of President Trump's campaign promises. In not particular order, they were:

1. Withdraw from TPP

2. Halt T-TIP negotiations

3. Renegotiate or scrap NAFTA

4. Institute a border tax (tariffs) with Mexico so as to pay for a wall on the Mexican border

5. Declare China to be a currency manipulator

6. Impose a border adjustment tax (BAT) as part of the tax reform package that should be forthcoming from the administration.

The first 2 on the list have now been completed, but the third is the one that has everyone guessing as to the consequences, so let's look at NAFTA first. 

NAFTA is now embedded into the North American economy, so changing the basis of the Treaty that established NAFTA requires a summit with both Canada and Mexico, and the negotiations for this summit are now taking place. 

President Trump has made it clear that he wants a complete rewrite of NAFTA, and that led to a tense start to the negotiations, which got underway this week (see here). The Canadian foreign minister, Chrystia Freeland, noted that “We pursue trade, free and fair, knowing it is not a zero-sum game”. She added that: “it is worth pointing out that we are the biggest client of the United States. Canada buys more from the U.S. than China, the UK and Japan combined.” 

Perhaps the US team in the negotiations, led by U.S. trade representative Richard Lighthizer, sees trade bilateral deficits ( - and the US does run a small deficit with Canada) as a measure of fairness of trade with that entity.  Any student of international economics understands that this is not the case - it is simply a component of the overall trade balance, and reflects a balance of comparative advantages between the two countries. Also it should be noted that Trump's ire has not been directed at Canada (with the isolated case of the softwood lumber issue) but in the NAFTA context his ire has largely been directed at Mexico. This is because whereas the U.S. ran a goods and services trade surplus with Canada in 2016 of about $12.5bn, the U.S. ran a goods and services trade deficit with Mexico of $55.6bn.  But as we shall see below, the trade deficit with Mexico is dwarfed by the trade deficit with China.

Now although the topics to be discussed are rules of origin, managed trade (read more quotas), and so-called "Chapter 19" dispute resolution, whatever is in NAFTA 2.0 better reduce the U.S.'s trade deficit with Mexico, otherwise this will likely prompt President Trump to threaten withdrawal from NAFTA. But given the fact that much of the trade between the U.S. and Mexico is intermediate goods trade, it does make sense that the biggest part of the cross border trade would be the finished product (for example a vehicle), rather than the sum of all the parts that might be produced in the U.S. that are exported to Mexico (where the vehicle is then assembled). Given then that it is unlikely that trade with Mexico could ever get to close to in balance (or in surplus), I think that President Trump, given that he has made such a big issue of either pulling out of NAFTA or completely rewriting it, may decide to pull out if the Mexicans don't walk out first.  

What I think will possibly transpire is a return to CUFTA, which was the free trade agreement with Canada that formed the original basis for NAFTA. Although other economists might not agree with my assessment, I believe that President Trump will feel that he has to deliver on this particular promise if he is to stand any chance of re-election.  In order for NAFTA 2.0 to eliminate the trade deficit with Mexico would be import quotas.  I think these will be rejected by Canada, as they would also affect Canadian exports to the US. So there is no way forward that would satisfy all 3 parties and therefore this will possibly lead to withdrawal. Since the announcement of Steve Bannon's ouster as a Trump advisor, the probability of withdrawal has gone down, but the trade representative will still have difficulty delivering what the President wants out of a re-write of NAFTA.

When campaigning, Donald Trump also mentioned a 35 percent tariff on autos made by U.S. companies in Mexico. This tariff was originally mentioned with regard to also funding construction of the wall. This tariff would currently go against the rules of NAFTA so is unlikely to be implemented while the U.S. remains inside NAFTA. So if the U.S. does leave NAFTA then this idea might get resurrected as a means to deter manufacturing or assembly going south of the border.

On the campaign trail President Trump also promised to name China as a "currency manipulator".  But having met with Premier Xi Jingpin, Trump declared that China had manipulated its currency in the past, but was moving to correct the level of the yuan, and hence it would not be necessary to name China as a "currency manipulator".  So this is now off the table.  President Trump did, however, decide to pursue several probes against China, most notably on intellectual property (see here), but also on steel. Although the U.S. has not imposed steel tariffs yet, it seems that they are likely to do so (see here).  This so-called "section 232" review ( - that was initiated because of fears that threats to the U.S. steel industry from imports would not be in the interests of national security) has to be made public by mid-January. Then President Trump will have 90 days to react, perhaps implementing a steep tariff on steel imports principally from China, but also from all other steel producers.

The Border Adjustment Tax (BAT) has now also been abandoned as a proposition, but just to keep my readers fully informed, I will explain exactly what a BAT is. A BAT is essentially an import tariff coupled with an export subsidy by means of making exports tax free.  

So that is the current state of play on international trade policy and the Trump administration. As mentioned above, the current administration appears to be particularly concerned about turning the overall U.S. trade deficit into a surplus, or at least reducing it.  In the table below from the BEA, the bilateral trade deficit or surplus for the U.S.'s main trading partners is shown, and it can be seen that the majority of the deficit is with China, and this is fairly consistent over time. 

Source: US Census Bureau, Dept of Commerce

Of course what really matters here is the trend in the data, so I thought I would download the data and see exactly how a long term perspective can show that actually China is pretty much the only problem. 

Data source: Dept of Commerce; Graphic by blog author
Now the graphic clearly shows that although there was a deterioration in the trade balance with countries like Japan, Germany and Mexico over the early 2000s, it is the trade deficit with China that really takes off in the early part of the century, and although for countries like Canada the trade balance has actually improved, for China, with only a brief respite during the great recession, the overall trend has been towards a widening of the deficit.

Chinese President Xi Jinping and U.S. President Donald Trump shake hands
So from an economic assessment, if one agrees with this approach, the President should really focus mostly on China, as this is where much of the trade deficit originates from. But what is the best way to tackle this? The U.S. trade representative has a detailed list of objectives which can be found here, but of course these only state objectives and not solutions.  

On a recent trip to China I visited a large container port off the coast of Shanghai ( - in fact it is at present the largest container port in the world), and was surprised to hear that half of the containers travel to China empty, but every single container is full leaving China. So the main problem with trading with China (and this goes for the EU too), is that China's trade with most of the rest of the world is unbalanced.  

This highlights the fact that although half of this problem is the U.S.'s problem, the flip side is that China clearly has a lack of consumption of imports in the sense that savings are high and when the Chinese do consume, much of their urban dwellers consume Chinese goods. The China issue prompted President Trump and President Jinping to set up a "US - China Comprehensive Dialogue", but as reported in the Financial Times last month (see here), this dialogue is a talking shop regarding the issues to be tackled, but nothing concrete to make it happen, and definitely no sign of agreement on the way forward. 

Clearly the Trump administration has changed tack and instead of calling the Chinese currency manipulators, has decided to go after the Chinese on various fronts by launching probes in specific problematic areas. The results of these probes though, if acted upon, will likely prompt reprisals, and perhaps WTO arbitration cases against the U.S. Certainly the Chinese appreciate that although the U.S. is not their largest trading partner ( - the EU is), that there are considerable risks to domestic economic growth if there is a trade war with the U.S.

So is a trade war inevitable with China?  I think that the answer here is still up in the air, but I still think the most likely outcome is narrowly in favor of a trade war. This is the case particularly if we see a degradation in the NAFTA talks appearing over the next few weeks.  A sign pointing in a different direction has also appeared though, and that relates to the earlier probe on steel which the President launched. There has still been no announcement as to the results of this probe, and this is likely because the announcement has been held back as it would be damaging to trade with China. How to handle this will definitely require some diplomacy, as President Trump will not want to make outright enemies of the Chinese.   

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