Minute By Minute

Author: Robert Eisenbeis, Ph.D., Post Date: July 9, 2018
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The FOMC June minutes were released this past week, along with the Committee’s most recent predictions as detailed in its Summary of Economic Projections (SEPs).

Although the press gave attention to the Committee’s views on the implications that the tariffs soon to be implemented might have for growth, in reality the minutes devoted only a couple of sentences to concerns that district contacts had about tariffs. Specifically, “… many District contacts expressed concern about the possible adverse effects of tariffs and other proposed trade restrictions, both domestically and abroad, on future investment activity; contacts in some Districts indicated that plans for capital spending had been scaled back or postponed as a result of uncertainty over trade policy.” Potential impacts on steel, aluminum, and agricultural prices and exports were noted.

While the minutes were largely unremarkable overall, there were a couple of points of emphasis that were different and potentially interesting. For example, the manager of the Open Market Desk pointed out that paydowns and maturing MBS were likely to fall short of the caps that had been established (the max for MBS being $20 billion per month), indicating that reinvestment in MBS was likely to be unnecessary and implying that shrinkage of the MBS segment of the System Open Market Account portfolio would be less than planned. Indeed, as of the end of June, the shrinkage of the aggregate portfolio was about $22 billion short of target, and at the present pace the shortfall will be much greater by the end of July.  Having said that, paydowns could, depending upon what happens to rates, again exceed the target reductions in MBS. So as a contingency, the Desk staff proposed continuing to make small MBS purchases to maintain operational readiness should redemptions exceed the targets and purchases again become necessary.

Additionally, the Committee appeared to have spent considerable time discussing the strength of labor markets and the implications that had for potential wage increases. As for risks, the Committee again noted policy uncertainty, especially with respect to trade policy and the negative implications for investment and business sentiment.

The most interesting discussion, however, in the entire set of minutes was the attention that was paid to the flattening of the yield curve and what, if any, signal that trend may have as a harbinger of a future recession. Several factors in addition to the tightening of policy were seen as possible contributors, including a reduction in the longer-run equilibrium rate of interest, lower inflation expectations, and a lower term premium, in part related to central bank asset purchases. Views appeared to be mixed and relatively split between those who felt that the above factors reduce the meaningfulness of a flattened term structure as an indicator of recession probabilities and those who felt that the flattening curve is still a useful indicator. Staff apparently presented research looking at the usefulness of measures of the spread between the current and expected federal funds rate derived from futures markets as predictors of recessions. In general, the System has continually devoted attention to yield-curve inversions as predictors of recessions, and the general conclusion is that a negative yield curve has led all but one recession since 1955, with a lag of between 6 and 24 months.[1] Bauer and Mertens’ most recent work shows two key things. First, while inversions may signal an increase in the probability of a recession, at the critical threshold of a zero spread, the probability of a recession 12 months ahead is still only 24%.[2] They also note that as of February 2018 the estimated probability based upon the spread that existed at that time was still only 11%, which they viewed as “… comfortably below the critical threshold….”

As for the risks to the economy associated with the potential trade war initiated by the US, it is interesting to look at statistics on US and China trade relative to the size of their respective economies. Current estimates suggest that China’s GDP is about $12.2 trillion, while that of the US is about $19.4 trillion.[3] Of that, US exports of $1.4 trillion are about 7% of US GDP, and imports of $2.4 trillion are about 12.4% of US GDP. Trade is much more important to China than it is to the US. Chinese exports are 17.2% of GDP, and imports (which historically have consisted of raw materials and intermediate inputs to their exports) are about 15.6% of GDP.

US trade with China, especially the deficit, has gotten a lot of attention. However, US exports to China are less than 1% of US GDP, and imports are about 2.5% of GDP. As of this writing, the administration has imposed tariffs on about $35 billion of US China imports, or about 0.2% of US GDP. While these appear to be small numbers, the impacts on certain US industries in many parts of the country, such as soybean farmers in the Midwest, are critically important to their well-being. Unfortunately, what the present approach to trade implies is picking winners and losers who bear the brunt of attempts to rationalize international trade policies, but is based upon the faulty logic that the US must have bi-lateral trade balances  with each of our trading partners.[4]  The political fallout from the coming trade war will be significant, but the immediate worry is not the overall economic impact, which by most measures is small.  Rather the more significant effects will be the impacts that tariffs may have on market psychology and business investment attitudes and decision-making. The emotional impacts may drown the real economic impacts.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
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[1] As but a small snapshot see: Bauer, Michael D., and Glenn D. Rudebusch. 2016. “Why Are Long-Term Interest Rates So Low?” FRBSF Economic Letter 2016-36 (December 5); Berge, Travis J., and Oscar Jorda. 2011. “Evaluating the Classification of Economic Activity into Recessions and Expansions.” American Economic Journal: Macroeconomics 3(2), pp. 246–277; Estrella, Arturo, and Frederic S. Mishkin. 1997. “The Predictive Power of the Term Structure of Interest Rates in Europe and the United States: Implications for the European Central Bank.” European Economic Review 41(7), pp. 1,375–1,401; Mertens, Thomas, Patrick Shultz, and Michael Tubbs. 2018. “Valuation Ratios for Households and Businesses.” FRBSF Economic Letter 2018-01 (January 8); and Rudebusch, Glenn D., and John C. Williams. 2009. “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve.” Journal of Business and Economic Statistics 27(4), pp. 492–503.
[2] See Bauer, Michael D. and Thomas Mertens, “Economic Forecasts with the Yield Curve,” FRBSF Economic Letter, March 5, 2018. https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve/
[3] https://tradingeconomics.com/china/gdp; https://tradingeconomics.com/united-states/gdp
[4] Alan Blinder has a useful discussion of what we know about trade balances in WSJ July 9, 2018.

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