Expectations

It may be a bit early for the annual economist exercise of forecasting the year ahead, but nothing about this year has been normal. We are doing good to predict next Tuesday, much less next year. Nonetheless, there is demand to plan, and business leaders need some idea as to what is to come. It is time to trot out some scenarios.

We can start with the bad news option and work our way to something a bit more upbeat. There is a school of thought that holds that most of the negative developments expected in the first part of the year will arrive in the second half. There are signs of this already. Inflation is rising despite some relief in sectors such as energy. The tariff impact is being felt as companies have worked through the extra inventory they loaded up on earlier. The initial response to the tariff threats were expected, but they still altered a great many expectations as far as the economy was concerned. Companies started loading up on inventory as they anticipated higher prices. That triggered a major surge in imports, and that contributed to the severe slowdown in Q1 GDP. Once that surge in buying ebbed, the GDP numbers returned to normal, but more importantly, the pad that had been provided by that extra buying vanished.

In the second half of the year, there will be reorders, and these will be much more expensive. That triggers inflation. Slowdowns are becoming common as business tries to cope with all the uncertainty. That means reduced hiring and increased layoffs, as well as reductions in capital investment. After a pretty solid GDP number in Q2 the estimate is for Q3 GDP growth at 1.4% with some asserting it will be even lower. Two assumptions are driving this pessimistic outlook. The first is that tariff chaos will not decline and is likely to accelerate. There had been hope that tariffs would settle into a pattern by now, but they have not. Massive new tariffs have been imposed on India, Switzerland, Australia, Canada, and many others. The second is that consumers will react negatively to the inflation numbers and will significantly reduce their spending. Retail numbers have been holding their own, but only because the upper third of income earners are still active. The other two-thirds are living paycheck to paycheck and have been falling behind due to inflation. This scenario is dominant right now with a 60% probability.

Next up on our cavalcade of economic possibilities is the not-quite-so-bad scenario. This one asserts that inflation due to tariffs will be mostly sectoral. There have already been many deals and changes that have reduced tariffs or at least limited them. China is actually getting the majority of these tariff breaks. The nagging problem is still the lack of certainty. I know this sounds like a broken record, and it is legitimate to ask when there has ever really been certainty in business. There is always change as consumer demand shifts, competitors develop new strategies and so on. What makes this period different is the speed of change alongside radical changes of direction. Nobody can plan when the price of an input can surge by 50% one day and fall back the next. Companies have been doing everything they can to reduce the impact on consumers as they remain focused on defending market share, and that strategy may well continue for the next several months. The sectors that are hit by high tariffs will have little choice but to hike prices, and that is likely to cascade through the economy. In this scenario, there will be lots of caution but few immediate reactions. There will be fewer new hires, but layoffs will not accelerate. This scenario is looking at a 25% probability, as there is an assumption that affected businesses will figure out a way to adapt (provided there is some stability eventually).

This leaves the “unicorn scenario”. This sees a stronger conclusion to the year with GDP growth in the 2.0% to 2.5% range. This is based on assumptions as well. The first is that tariff policy settles down as most nations in the world start to adjust to a new reality, but one that will not be changing every other day. There will be more reliance on NTBs (non-tariff barriers) as these are more stable and have been relied on by the US for protection for years (73% of import restrictions have been due to NFBs). The inflation threat starts to fade, and rates remain around 3.0% as compared to the prediction of 4.5%. Hiring and investment returns to more normal rates as business starts to see more stability. Lower inflation risks may also convince the Federal Reserve to start reducing rates. Lowering rates will not automatically stimulate the economy, as there is a next step after the rate decline. It is up to businesses to take advantage of the lower rates to borrow and invest. If there is doubt, uncertainty, and concern regarding consumer mood, there will be less interest in borrowing – regardless of the rates. Lowering rates is compared to pushing a string, while hiking rates is pulling that string. It is hard to get the string going in the right direction when one is pushing it. More stable trade policy may convince more companies to return production to the US and would encourage foreign companies to build facilities in the US. As appealing as this scenario is, the chances are considered very slim. There has been no sign of tariff stability, and without that, there is little opportunity for progress. This has a 15% chance, and most think that percentage is generous.

There you have it – an early set of prognostications, but remember the comment from J.K. Galbraith. “There are two kinds of forecasters. Those who don’t know and those who don’t know they don’t know”.