TARIFFS, THE LAST FED MEETING OF 2024, AND THE SEARCH FOR NEUTRAL

This has been quite the year. We began 2024 with markets having strong assumptions on the magnitude of interest rate cuts from the Federal Reserve. And the initial comments from Federal Reserve Chair Jerome Powell in late 2023 simply ‘mentioning’ interest rate cuts wore off in short order with higher inflationary readings in the first quarter of 2024. In fairness, and something to be aware of as we look toward 2025, the seasonal impact of inflation projections has proved firmer than expected in the first quarters of both 2023 and 2024.

This year is ending with an overriding focus on global governments, fiscal policy, and geopolitical developments around the globe. The latest focus on Syria which although a welcomed unfolding of President Bashar al-Assad remains uncertain in development. And to quote President-elect Trump, “Something seems to be a little crazy in the world right now.” But we do believe there is light at the end of the tunnel.

In the United States an administration that will be new in ways. But not new to the scene in Washington and able to move very quickly in thought. Thought that looks toward the future and offers potential “transformation.” In other cases, potential increased tariffs, and a playbook that resembles 2016-2019 before the pandemic disrupted our global lives. It all remains a fluid work in progress but one that is moving quick.

The question we believe investors face moving forward: Can we have continued higher deficits short-term (Focus on spending bigger picture, DOGE), strong real growth and wages, inflation stabilizing between 2-3%, and with lower interest rates albeit at a slower pace. “Lower but slower” is the Federal Reserve’s new mantra. We believe the answer to that question is, yes.

But it will require a keen focus on the supply side of the economy, productivity levels which have rebounded over the past few years, and regulatory changes that encourage further innovation. Supply side focus and regulatory change present likely. How productivity evolves will be an important part of the interest rate story.

Productivity levels through decades with a rise in the longer-term rate last updated on November 7th.

So, what about these potential tariffs?

On November 25^th, President-Elect Donald Trump announced his intentions to impose additional tariffs on China of 10% and increases of 25% for both Mexico and China. This was well-telegraphed throughout the campaign and has reignited a debate on whether tariffs are inflationary or not. And the role they could play in the global economy.

What is a tariff? A tariff is a customs duty levied on imported and exported goods and services. Historically, and dating back over one hundred years, tariffs were a means of revenue collection. Today, most other taxes account for the majority of government revenue in many developed countries including the United States. Tariffs are now used during trade negotiations and to protect domestic industry.

Context on tariff size: Following World War II and the General Agreement on Tariffs and Trade (GATT, 1947) tariff levels were declining until 2018. And despite the initiating of the tariffs on China under the former Trump administration, the current Biden administration has kept many of the tariffs on China and in some cases at increased rates. At roughly $80 billion in fiscal year 2023 out of a total revenue of over $4.4 trillion, tariffs comprised a small portion of total government intake. And the Congressional Budget Office (CBO) estimates that customs revenue from 2025-2034 will total an estimated $872 billion which accounts for just 1% of total revenue projected through that period.

Federal Revenue Trends Over Time, FY 2015-2024

Inflation Adjusted – 2024 Dollars

US Department of Treasury, Bureau of Labor Statistics

Who Has the Authority Over Tariffs? Congress has deferred to the President through legislation enacted in 1934 (The Reciprocal Tariffs Act), 1962 (The Trade Expansion Act) and the Trade Act of 1974. Although the US Constitution stipulates the power of tariffs in the hands of Congress. During the President-elect’s first term he enacted $80 billion in tariffs utilizing the Trade Expansion Act of 1962 and Trade Act 1974 with a focus on China. In 2019, and pursuant to the International Economic Emergency Power Act (IEEPA of 1977), the President announced up to 25% tariffs on Mexico unless they address issues at the border. Overall, Congress has given power to the Executive Branch that incorporates issues of foreign policy and national security. Specifically, the Trade Expansion Act of 1962 has a focus on national security issues. The administration of tariffs into the United States is done through ports of entry by the U.S. Customs and Border Protection (CBP) with oversight from the Department of Treasury and once enacted take some time but relatively easy to implement.

Are tariffs inflationary? It’s simply not conclusive they are despite the recent narrative as such. Certainly, tariff wars benefit few and would likely result in slower growth. But increased costs can be absorbed a number of ways: 1) The exporter can choose to absorb the cost 2) An importer may choose not to pass on costs 3) And of course to consumers, through higher prices if the producer senses they can pass the costs along. Depending on how the tariffs develop it could very well impact growth (lower) too. There is no exact formula despite the narrative, and it depends on the product, material, and consumer choices over time.

Looking below the period of 2016-2019, the chart shows the Producer Price Index (PPI) increasing, the Fed’s favored PCE Deflator not as impacted just barely reaching 2%, and the Federal Reserve moving from tightening to easing from late 2018 to 2019 before the pandemic arrived. Given that tariffs are often imposed on goods used to “make things” the slight rise in producer prices seems to make sense. The impact on growth and ability to pass costs along becomes important. One can make a legitimate argument that this time around could be different as we continue to work through this post-pandemic inflationary period. But the consumer presents as exhausted by the higher prices of the past three years and tariffs could very well hurt company margins instead.

 

Producer Price Index (White), Personal Consumption Expenditures (Blue), and the Effective Fed Funds Rate (Orange)

Tariffs and China

Of late, comments coming out of China with relation to Nvidia and chips. And furthermore, a key component of global trade, which is currency. Overnight there have been comments from Beijing about further Yuan weakening. The below chart on the spot USDCNY, price of $1 dollar in the Chinese Yuan. Keep in mind that some of the gyrations have occurred within pockets of central bank movement. But when a country has the ability to set currency levels, we operate on an uneven playing field and tariffs become necessary. As the Fed settles into a more stable posture on rate policy in 2025, movements in the chart below become more revealing.

 

 

USDCNY Spot Rate (2012-present)

Will Tariff Policy Impact the Federal Reserve and Monetary Policy?

We are taking a measured view on potential policy around tariffs. What appears clear from history and revenue numbers is that they are much more of a negotiating tool than revenue grab. There has been talk about replacing income taxes with tariffs. The numbers would never allow it. And 100% tariffs on the BRICS either. We view smart regulatory reform, government efficiency, energy, and tax policy, as far more relevant. And with regards to Mexico and Canada their economies are extremely reliant on exports to the United States. So, negotiations will be ongoing there. But as outlined above, for two administrations that differ widely on many issues, policy with China is not one.

For the Federal Reserve, we sit in their blackout period. There is a spirit of gradualism and caution looking ahead to next week’s rate decision. “Lower but slower” is how we have been coining it. Chair Jerome Powell noted recently that the data since their 50-basis rate cut in September has been ‘better than expected’. An interesting comment as the market prices another 25-basis points for the last meeting of 2024 on December 18^th. Our call from early on in 2024 was that the Fed would look to recalibrate 100-basis points initially. Another 25-basis points next week will get us there. With the notion that the outsize 75-basis point moves in 2022 was designed for calibration. But the magnitude of the US Treasury market’s rate increase since September has caught many off guard. Of late moving back the other way. But as Chair Powell indicated the data has been better than expected.

With that, animal spirits are alive and were even before the election. Chair Powell has indicated the Fed does not “guess or assume” what fiscal policy will look like. And the recent FOMC Minutes show a heightened concern over the exact level of the neutral rate and the speed in which to get there. The Fed will finish out the rate-cutting cycle for this year on December 18th. And in their new Summary of Economic Projections, they will indicate a pathway down toward 3-3.5% but spread out over the next few years, lifting both their 2025 and 2025 median rate projections. A different cadence depending on how the economy and fiscal policy evolves. They could remain on hold for all of 2025 depending on how the fiscal side develops.

In general, though, we view monetary policy as well-positioned. The last thing markets would welcome is the need to begin moving back toward higher rates. We have long felt, believed, written, and spoke of the opportunity the United States has in front of us with economic weakness abroad. It is not about today, tomorrow, or next week. It is structural, very real, requires tons of work (sacrifice in the US too), and the moment is upon us. Yet, at the same time understanding the gap between thought, intentions, and reality will play into 2025. And despite market moves of late does leave economic and market uncertainty in the new year.

For now, we are probing and forming a new post-pandemic range in US Treasury rates. Demographics, productivity, technology, policy, deficits, and currency are front and center. Inflation has not gone away but the rate of change has slowed. Overall prices will be addressed but will take some time. Growth can suffer if tariffs and policy become retaliatory.

UST-10 Year Nominal Yields Sums Up a Ton (2014-today)

The UST 10-year matters in times like this. It is the global benchmark. Great chart since 2014 above. It includes all the tariffs, a global pandemic, China, multiple US Treasury Secretaries, 3 US Presidents, multiple wars, inflation that took off to the moon for a period. And a picture of normalizing rates which we have not seen in an exceedingly long time. This latest yield concession from September through election night has once again created a nice opportunity to add fixed income to portfolios.

But as long as the economy remains firm, and deficits remain large we will continue to form a larger range. We expect market activity to be robust in 2025 but like the past few years the inflation readings could be bumpy to begin the year. We have had 4 monthly core CPI readings now of .3. That is a trend. The housing components were helpful and welcomed. And just in time for the Federal Reserve to deliver one more rate cut and pause. Our view of recalibrating 100-basis points is here but so too is the time to breath and let this new change of course in Washington play out.

Happy holidays and much more in 2025!