‘We’re Closer To’ Recession (Uncut) 02-18-2025

‘We’re Closer To’ Recession: BNY Chief Economist On Trade War’s Worst Case Scenario

Tariffs work. United States has a big trade deficit. What does that mean? It means that our exports are a lot smaller than our imports.

When we put on a tariff, it’s on imports. When we get retaliation, it’s on our exports, i.e. the retaliator hits us less than we hit them in terms of quantity. The EPI report came out on Wednesday.

Headline came in at 3%, up year-over-year from 2.9% the previous month. This was higher than expected. Core inflation also rose 3.3% in January.

The rising inflation data have some investors worried and have diminished the chance the Fed will cut by the next meeting. Furthermore, consumers’ expectations for inflation fears have spiked in recent months as tariffs are introduced. We’ll talk about the impact of tariffs on the inflationary landscape and economic growth overall with our next guest, Vincent Reinhart.

He is the Chief Economist at BNY Investments, previously Chief U.S. Economist and Managing Director at Morgan Stanley. Welcome to the show, Vincent. Good to see you.

Pleasure to host you. Thank you for having me. Let’s just start with your reaction to today’s CPI report.

Higher than expected, according to the street’s consensus, was higher than your expectations. It was higher than expected, but not for that surprising reason. Last mile in reducing inflation is hard because a good chunk of the consumer price basket, something like 70% of it, is comprised of very slow-moving components, things set by contract, things set by local markets, not done all at the same time, done by people worried about market share, worried about sense of fairness.

They just don’t have a momentum and they keep heading in the same direction. And it’s a while before everybody gets to adjust their prices. And the fact is, we still have some more price level adjustment to do for those sticky prices.

The fast-moving stuff, the energy prices, commodity prices generally, they’ve made their adjustment. They made their adjustment in 2021 and 2022 and have, in fact, mostly been a source for disinflation, except last month. And it’s interesting how last month’s inflation came in harder than expected.

Keep in mind that tariffs, which were just introduced, have not had time to feed into the inflation numbers yet. And so consumers are probably wondering whether or not we should even be worried about tariffs, or are there bigger forces driving this inflationary force out there that we need to be worried about? Okay, so in terms of inflation dynamics, besides policy, there’s three moving parts. The first is actually about price levels, that goods prices relative to service prices basically move downward over time because we’re way more productive in goods making than in service making.

Goods prices are too high right now, so service prices have to catch up to them. That adds a little impetus to inflation. Goods prices are very sensitive to global supply chains.

And service prices are very sensitive to excesses in the labor market. Hard to get service inflation down once it gets going, but excesses in the labor market can push service inflation up. So what’s happening now? We have a little inherited source of inflation as a key relative price tries to get back into line, goods relative to service prices.

We’re doing better on global supply chains, they’re healing, that’s a source of disinflation. And service inflation has its momentum, not added to by current excess, but it’s still just adjusting. And Fed’s strategy is patience, just hope.

Hope global supply chains keep healing, live with the slow adjustment to get the relative price back in line, and make sure you don’t create a labor market imbalance that adds to inflation. If you get all those parts in place, then inflation will slow some more over the course of 2025. Bad news is I didn’t talk about any changes in policy, i.e. tariffs.

But where we are is inflation’s still with us, relative prices still have to adjust, it’ll take a little bit longer, the last mile in reducing inflation is hard. So do you think that the Fed should cut rates? Forget what they would do, but in your opinion, whether or not they should continue rate cuts into the rest of the year? Okay, good thing you said rest of the year, certainly wouldn’t do it at the upcoming FOMC meeting. Maybe in retrospect, as we were saying at the time, starting out this easing cycle with a big 50 basis point cut wasn’t prudent.

I think the Fed is in position to cut rates in 2025, because it’s gonna want to lower the federal funds rate in real terms. That is, if the nominal funds rate stays where it is, and inflation, like in our forecast, edges lower, then the funds rate in real terms will be rising. That’s not supportive of aggregate demand.

And we don’t need outright slack. So in that environment, what the Fed can do is wait to realign the nominal funds rate to make sure the real federal funds rate doesn’t rise as inflation starts falling. But it’s got to see more progress in reducing inflation.

Well, let’s talk about tariffs now. Policy changes, like you referenced earlier, President Trump earlier this week signed an executive order that will make all steel imports taxed at a minimum of 25%. He also hiked his 2018 aluminum tariffs to 25% from 10%.

Take a look at what he said, and we’ll react to this clip, please. It’s a big deal. It’s a big deal.

This is the beginning of making America rich again. Basically, this is aluminum, the same thing, no exceptions, no nothing. And it’s going to bring our aluminum business back and may go higher.

I mean, frankly, it may go higher. And we’re going to also be talking about receptive, we’re going to be talking about things over the next three weeks that I think will be amazing for our country, amazing for our jobs, and will bring us to a new level of prosperity. It’s time to be reciprocal.

So very, very, you’ll be hearing that word a lot, reciprocal. If they charge us, we charge them. If they’re at 25, we’re at 25.

If they’re at 10, we’re at 10. And if they’re much higher than 25, that’s what we are too. So that’s having to do with everything.

That’s not just steel and aluminum. But we’ll be discussing that over the next couple of weeks. Okay, steel and aluminum tariffs up to 25%.

What is the immediate impact of the economy, if any? So first thing is, I think you should have shown that clip in black and white, because it really seemed to characterize the economy in the 1950s. The fact is, the United States is a service producing economy. Value added in goods is about 17%.

The labor force in US goods production is the same as it was in the mid 1960s. So what we’re talking about is something on the margin of our productive activity. What happens when you put a tax wedge? You raise prices.

A little more complicated for what this does to steel prices, because an exchange rate gets in between. If you’re putting a tax wedge on imports, the dollar value of that imports depends on what happens to the exchange rate. That’s why we didn’t see all that much pass through in 2017.

That’s why it’s hard to predict what’s going to happen here. It’s usually safe to say, put a tax wedge, price is going to go up. It will go up less because probably the exchange rate is appreciating for lots of other reasons.

In that environment, it is a small cost to an important input in production. You’re not really going to see it on the CPI in three months. Let’s comment on what Trump said about reciprocal tariffs overall being quote unquote amazing and will bring the economy to a new level of prosperity.

Can you comment on that? Not generally the way neoclassically constrained economists think. The case for free trade is pretty overwhelming. However, empathy is important.

Why might you argue that tariffs work? What tariffs are useful a tool in the toolkit of macro policymakers? I think the White House believes they’ve got leverage for a couple reasons. Number one, the United States has a big trade deficit. What does that mean? It means that our exports are a lot smaller than our imports.

When we put on a tariff, it’s on our imports. When we get retaliation, it’s on our exports, i.e. the retaliator hits us less than we hit them in terms of quantity. Second, as I already said, we’re a service economy, not a goods economy.

Among the major advanced economies, we have the smallest global footprint of activity on our domestic economy. Number three, a lot of the goods that matter for households, that is actually show up in consumer prices, as opposed to indirectly like an intermediate input of production like steel or aluminum, a lot of those goods have a lot of margins, i.e. there is what the value added at the factory, there is transportation margins, there is retail margins. And so they can adjust somewhat to take account of increases in costs.

So I think that the White House believes they got leverage because they got a tool that hurts other economies more than they. If a tariff is used transactionally, i.e. we’re going to raise this tariff unless you do something else, do something, then it’s hard to get too excited about the incidence of it because it’s going to go away. And it’s possible that you’ll get other better policy outcomes as a consequence.

Right now, hard to know if this is transactional or is this the new world. If it’s the new world, it’s disappointing to an economist because that new world has less trade, less contribution to economic dynamism from the international sector. It has, in fact, impaired household choice.

Well, actually, the counter argument to what you just said, Vincent, if I may, is that Canada, for example, agreed to put 10,000 patrol officers on the border, agreed to a fentanyl star, among other conditions that Trump wanted right away, right after he announced a 25 percent tariff on Canada. Then he rescinded that after those conditions were met. The counter argument here is that those agreements would have taken much, much longer had he not put his hammer down.

How would you respond to that? That’s the transactional nature. If tariff is viewed transactionally, i.e. as a lever to get different other policies, then it’s not going to have much of an economic incidence directly because they’re going to go away. And if the lever was used to produce better policies, then you probably shouldn’t complain about it.

It upsets the norms of the discussion among countries, and there are probably long lasting consequences to that. But if you told me tariffs, the average stay on the books of a tariff is, in this case, under 24 hours, it’s not going to have macro significance. I understand.

How would you evaluate this statement from JPMorgan Chase chief Jamie Dimon? If it’s a little inflationary, but if it’s good for national security, so be it. I mean, get over it. You told CNBC during Davos, national security trumps a little bit more inflation.

First of all, do you agree? What is the national security aspect of the tariffs? So this is the aspect. So first part is, was I surprised that the president was putting tariffs in place? The answer is no. He ran consistently talking about tariffs.

If you look at the precedent of 2017, he followed through on his threats of tariffs. So he characterizes himself as a tariff man. We should take him for his word up for that.

So tariffs are part of the toolkit that this White House is going to rely on early. So that part wasn’t surprising. In some sense, I was a little bit surprised it wasn’t in the inaugural address.

What has been surprising is the justification that it has been not on market power grounds, it has been on national security. Among other things, it lets you implement them a lot faster and creates a certain bar that in particular, a court is less likely to contest. I mean, you elect an executive in the United States to execute national security.

And if it’s in their judgment, this is something about national security, then it’s harder to contest that. So I think Jamie Dimon is right on the optics of it all. If the reason is national security, then we should have a higher bar.

Now, it’s also all right to question whether that, if it really was a national securities grounds, I’m not sure I would rank Canada and Mexico as high on my list of global threats, as intimidating as you are. We try to be nice. Yeah.

Isn’t that irritating sometimes? No, just kidding. So national security, I think, raises the bar for judging a policy just because you don’t know what is in the daily communications briefs that the White House gets from the security agencies. In this particular case, probably good reasons to question that.

But it sets a precedent, and I think you’re going to see the administration cut to national securities as the reason for doing lots of things. Well, I’m going to show your report on this issue now, Vincent. You have a map showing the impact of tariffs on several countries.

This map highlights the total bilateral trade, imports plus exports with the U.S. as a percentage of GDP. The darker colors, red, are more heavily reliant on trade with the U.S., and the lighter colors, yellow, are less. It’s interesting upon first glance at this is that the most impacted countries tend to be allies of the U.S., in fact, NAFTA countries plus Vietnam, right? And then you have countries considered so-called adversaries like China, which, according to this map, aren’t as dependent on trade with the U.S. as its allies.

So this begs the question as to whether or not tariffs are actually impactful in the global policy sphere as maybe Trump would have intended. Okay, a couple points. The first is I think that’s part of the reason the administration thinks they’ve got leverage is the U.S. has a bigger footprint on a lot of countries than other countries have on the U.S. Unfortunately, it’s a footprint on more likely to be our friends than our competitors.

Exactly right. And actually, it’s sort of a missed point in this whole discussion. China is the second largest closed economy in the world.

The U.S. is first. But China imports and exports relative to GDPs only is below a third. We’re at a quarter.

So the two biggest sparring partners in this contest actually are hitting more the people in the crowd than themselves. So it is an issue. If trade is just not that important to yourself, but it’s your friends, then there are real costs to trade restrictions.

I think the argument isn’t just, what are you doing to the price that people buy things at? It’s who produces it. And it isn’t just from the White House’s perspective now. It isn’t a question, well, you’re keeping a Canadian worker from producing it.

And that’s not as good as keeping a Chinese worker from producing it. The White House would say, ah, but we’re going to get an American to produce it. And that’s just better for the national interest.

So I think when they say national security, it isn’t necessarily hurting the trading partners. It is trying to help U.S. production. The unfortunate thing is, is the hurt to the trading partners in economics terms is probably larger than the benefit to the U.S. workers.

Trade restrictions are incredibly costly way of subsidizing work. This chart from Apollo research shows that 41% of revenue in the S&P 500 companies come from abroad. And the question is whether or not implementing tariffs will have a material impact on valuations for the large cap companies.

So part of what I think you’ve just answered is you’ve answered a mystery. And that sort of underlines some of your questions. Tariffs, that economists will tell you, have these adverse consequences.

Why are global financial markets so little worried by them? Yeah, they’ve sold off on days they implemented. They rallied the same day they rolled back. But end of the day, it’s not like you’re saying tariffs are leaving a big footprint on valuation of those U.S. firms that are so sensitive to the global economy and global profits.

The answer is right now, investors probably think that the White House is transactional, i.e. tariffs are a lever. They’re not going to be permanently in place. That could be wrong.

Well, then let’s discuss something that may be more permanent. Besides transactional tariffs, what headwinds, if any, do you see to economic growth in 2025? So part of it is how come we have momentum now? It’s been a couple of things. One is fiscal policy, past, present, and future.

The past part is fiscal policies, big transfers in 2020 and 2021, left households and states and localities with a nice cash cushion that they spent down over the past couple of years. And so this expansion is different than previous expansions. Normally, as the expansion rolls on and ages, sectoral balance sheets get worse.

But they haven’t. They haven’t because of that initial cash cushion. That’s gone.

It still might be there for states and localities, certainly gone for households. So a source of momentum and resilience has eroded. We are going to get continued fiscal stimulus, 6.25% budget deficit this year, according to the CBO.

They’re going to have to do tax legislation by the end of the year. It’s always a safe bet to say it’s more stimulus, not less. So we’ll get some fiscal stimulus.

Second, we’ll probably get financial stimulus unless markets get seriously spooked by tariffs. Equity prices are on higher net. Risk spreads are narrow.

The federal funds rate is higher in real terms. But it has stayed very low for a long time, giving momentum to spending. And the biggest problem in the global economy is global trade.

And as we’ve said a couple of times, trade’s not as important to us. So those were all the sources of momentum going in. Some of them are going away.

We’ve worked down those savings buffers. Uncertainty is just a deadweight cost to households and firms. Hard to plan when you’re not sure what your taxes will be.

Hard to plan when you’re not sure about the prices of important inputs because of tariffs. It’s hard to plan when you’re not sure of your global supply chains because what are you doing to your list of friends? In that environment, I would worry that uncertainty will be a force tending to restrain investment, offsetting potentially any benefit that the administration gets from deregulation. So biggest risk is uncertainty.

Next biggest risk is some of the benefits are eroding. And then third, yeah, we’re mostly closed. The US isn’t that much of an open economy.

But we’re not immune to the global cycle. And our trading partners are not in particularly a healthy shape. Jerome Powell has said even recently in a Banking Senate hearing that he is not in a hurry to cut rates.

Do you see any challenges to global liquidity this year? So there’s a couple things about that. The first is he’s not in a hurry to cut rates because there is the potential for large administration changes in administration policies that potentially could change inflation dynamics. And that if you’re the Federal Reserve, you don’t launch yourself off from the trapeze platform hoping the rest of the government will have good policies.

They may not be there. So I think Chair Powell is going to be patient because he’s going to wait for what gets demonstrated in the rest of Washington, DC. Global liquidity is going to be challenged then for a couple reasons.

One is the differential tensions. Because the Fed is pretty much alone in the community of central banks keeping its policy rate unchanged. European Central Bank, Bank of Canada, the Bank of England, they’re cutting rates.

And that difference in overnight rates because of the different monetary policies is going to put pressure on exchange rates. It’s going to put pressure on liquidity internationally. And meanwhile, the third largest economy in Japan has a central bank raising rates.

So lots of pressures there. Second reason on the Fed side about global liquidity is if they’re not inclined to cut rates, then they’re probably also not inclined to slow the current unwinding of quantitative easing, i.e., quantitative tightening. The Fed has been shrinking its balance sheet.

It’s taken off. It’s off about not quite $2 trillion of assets since it started not redeeming or rolling over maturing obligations. It will begin to contract to reserves.

It will matter as the Fed’s balance sheet shrinks. That’s a source of tightening global liquidity. And the first couple months of this year could very well be rocky because among all the other things going on, which you haven’t talked about, is you should worry about the debt ceiling.

The U.S. government needs an increase in the debt ceiling for the Treasury to issue new securities on net. It gets passed every time though, right, Vincent? It’s not something we should be worried about. No.

So look, it’s the ultimate game of chicken and games of chicken usually get resolved. And so I think market participants are trained. It gets resolved every time because the thought of it happening is so bad.

But I would also point out that the prototypical game of chicken in the movies is in Rebel Without a Cause, which have teenagers playing the game of chicken. Who is going to swerve and not run over a cliff? Well, what happens is at the end of the movie, Sal Mineo’s leather coat gets caught in the car door. Accidents happen and repeating a game of chicken is just inviting.

I asked this question rhetorically another day, which is why even bother having a debt ceiling anyway? Why not just make it infinity if you’re going to resolve it every single time and raise it every time? What’s the point? Yeah. So there’s a couple of things. I would reach into my pocket and pull out my red copy of the Constitution because I was in the room one of the times the late Senator Byrd of West Virginia did it.

The power to issue debt in the name of the United States government is granted in the Constitution to the Congress. Congress delegated it to the U.S. Treasury. But you don’t delegate a constitutional authority unless there’s a check.

And the check is the debt ceiling. Lots of ways the debt ceiling is silly. It’s a limit on a stock.

But Congress is the one that passes all the spending and taxing legislation. Why don’t they just do the math to figure out what it means for the amount of debt outstanding? Is it really much of a threat if, in fact, they pass it every time? The answer is Congress is not going to ever cede a constitutional authority. And so we’re going to live with it.

And in fact, as investors, we look from the outside and say, it doesn’t matter. It gets resolved every time. But if you are actually in the fray in Washington, D.C., you might believe that it’s actually useful leverage because every time somebody blinks.

So at least you can get something done. And to some extent, the use of the debt ceiling just tells you how dysfunctional the Congress is in normal times. They have to look for those rare bits of leverage to get what they want.

I understand. Finally, before we go, we touched on inflation a lot. The other aspect of Fed monetary policy is the labor market.

What is your expectation for labor market growth and or deterioration into the rest of the year? The last payroll’s numbers came in at, I think, 143,000 jobs added, which is below expectation of 170,000, but still strong. Yeah. And when you add revisions to the prior months, it was actually, it left you with the sense that 2024 was relatively robust.

Look, I think that I view the last year or so of the labor market where employment, monthly employment changes have been slowing on balance. If you really smooth them out as welcome, not worrisome, it meant that we were settling closer to trend. And that trend is in the low three digits.

It’s a number that starts with one, but doesn’t go much higher than that. And that if we can keep labor market balance, then we won’t add to inflation pressures. And service inflation is very sensitive to excesses in the labor market, not so sensitive the other way.

Slack doesn’t really make you much progress in reducing inflation. So avoid excesses. Slowing in employment growth’s a good thing.

We’re probably going to get even more slowing. And in some sense, unfortunately, that’s also a good thing. It’s unfortunate because that slowing in labor demand as the U.S. economy cools just a little bit more is probably going to be matched by a slowing of labor supply as we are less welcoming to immigration.

And so if so, we can continue to keep labor market balanced at unemployment rate just four to four and a quarter. That’s the corridor. Labor market stays in balance, but employment gains slow basically sequentially over 20 to 25.

The problem is you’re slowing the plane. You’re flying it closer to the ground. You’re more likely to be vulnerable to adverse nonlinear events.

A pilot would call that wind shear. An economist would call that a recession. And the chances of that happening if you were to sign a probability this year? I think it’s right to talk about probabilities.

It’s pretty darn low. I think it’s on the order of 20 percent. That’s low for the U.S. economy because just count the number of quarters in the post-war period and we’re in recession about 15 percent of the time.

So got a little elevated risk of recession relative to the norm. It goes up. It goes up next year.

Vincent, I appreciate your time. That was a very thorough discussion. Where can we learn more from you and follow your work? You can check our websites.

We’ve got a couple, Dreyfus.com and Mellon.com. And you can also just Google BNY Investments. BNY? All right. That’s simple enough.

We’ll put the links down below. Check out BNY Investments there. Thank you very much, Vincent.

Appreciate your time. Thank you. Thank you for watching.

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