Financial News for the Week of April 13, 2018

Politics dominated headlines this week. Financial markets recovered from last week’s selloff, as the fear of a full blown trade war between the U.S. and China receded for at least a few days. However, geopolitical tensions remain elevated as more economic sanctions against Russia took effect and the U.S. administration considers military action against Syria, providing a strong bid on gold and oil.

Although there has been more bark than bite on trade protectionism from the U.S. administration thus far, a hot trade war could do a lot of damage. However, events this week provide some hope that a trade war can be averted. Speaking at the Boao forum for Asia, Chinese President Xi repeated past promises to expand intellectual property protections and open various sectors of China’s economy to foreign investment. Later in the week, word spread that President Trump was directing officials to explore returning to the Trans Pacific Partnership, an agreement that he withdrew from shortly after coming to office.

With heightened uncertainty about the future trading relationship between the world’s economic heavyweights, business confidence could start to wane. Small business optimism pulled back in March, but the decline comes after the index reached a 35 year high in February. While a pullback was expected, one cannot rule out that rising trade tensions contributed to the greater-than-anticipated decline. What’s more, the report reinforced the labor market themes we’ve seen from the ISM surveys: rising labor shortages driving up wages as firms act to attract and retain workers (Chart 1).

Rising wages and input costs will eventually drive consumer prices higher. For the month of March, consumer prices rose 2.4% (year-on-year), but a more meagre 0.1% monthly change owing to decline in gas prices. Most importantly, core inflation (CPI ex-food and energy) ticked up to 2.1% y/y from 1.8% in the previous month, largely on the back of base-year effects (Chart 2). Still, core inflation rose a healthy 0.2% on the month, suggesting that a hot economy is leading to a broad build-up in price pressures.

Labor shortages, solid wage growth, and rising prices should reassure the Federal Reserve that higher interest rates are warranted. Although there was little new information in the March FOMC meeting minutes released this week, there were still some discussions worth noting. Strong economic growth along with rising price pressures are evidence that the economy is coping well with past rate hikes and can absorb more. In fact, some participants think that a total of four rate hikes may be warranted this year, while also suggesting that the language in the monetary policy statement be changed to reflect a view that interest rates are exerting a more neutral rather than accommodating impact on economic activity. Still, uncertainty about the ultimate impact of fiscal stimulus on output and the downside risks posed by trade protectionism is more consistent with a total of three rate hikes this year.

Fotios Raptis, Senior Economist | 416-982-2556