Although tariff negotiations continue, deals are being made,
shifting investor focus on assessing the fallout. Our Global Head
of Fixed Income Research and Public Policy Strategy Michael Zezas
and Chief U.S. Economist Michael Gapen consider the ripple
effects on inflation and the bond market.
Read more insights from Morgan Stanley.
----- Transcript -----
Michael Zezas: Welcome to Thoughts on the
Market. I'm Michael Zezas, Global Head of Fixed Income Research
and Public Policy Strategy.
Michael Gapen: And I'm Michael Gapen, Chief
U.S. Economist.
Michael Zezas: Today, how are tariffs
impacting the economy and what it means for bond markets?
It's Wednesday, August 13th at 10:30am in New York.
Michael, we've been talking about how the near-term uncertainty
around tariff levels has come down. Tariff deals are, of course,
still pending with some major U.S. trading partners like China;
but agreements are starting to come together. And though there's
lots of ways they could break over time, in the near-term, deals
like the one with Europe signal that the U.S. might be happy for
several months with what's been arranged. And so, the range of
outcomes has shrunk.
The U.S.' current effective tariff rate of 16 percent is about
where we thought we'd be at year end. But that's substantially
higher than the roughly 3 percent we started the year with. So,
not as bad as it looked like it could have been after tariffs
were announced on April 2nd, but still substantially higher.
Now's the time when investors should stay away from chasing
tariff headlines and guessing what the President might do next;
and instead focus on assessing the impact of what's been
done.
With that as the backdrop, we got some relevant data yesterday,
the Consumer Price Index for July. You were expecting that this
would show some clear signs of tariffs pushing prices higher. Why
was that?
Michael Gapen: Well, we did analysis on the
2018-2019 tariff episode. So, in looking at the input-output
tables, which give you an idea of how prices move through certain
sectors of the economy, and applying that to the 2018 episode of
tariffs – we got the result that you should see some tariff
inflation in June, and then sequentially more as we move into the
late summer and the early fall.
So, the short answer, Mike, is a model based plus history-based
exercise – that said yes, we should start seeing the effects of
tariffs on those categories, where the direct effect is high. So
that'd be most of your goods categories. Over time, as we move
into later this year or early next year, it'll be more important
to think about indirect effects, if any.
Michael Zezas: Got it. So, the July CPI
data that came out yesterday, then did it corroborate this
view?
Michael Gapen: Yes and no. So, I'm an
economist, so I have to do a two-handed view on this. So
yes…
Michael Zezas: Always fair.
Michael Gapen: Always, yes. So, yes, core
goods prices rose by two-tenths on the month, in June they also
rose by two-tenths. Prior to this goods’ prices were largely flat
with some of the big durables, items like autos being negative,
right? So, we had all the give back following COVID. So, the
prior trend was flat to negative. The last two months, they've
shown two-tenths increases. And we've seen upward pressure on
things like household furnishings, apparel. We saw a strong used
car print this month, motor vehicle and repairs. So, all of that
suggests that tariffs are starting to flow through.
Now, we didn’t – on the other hand – is we didn't get as much as
we thought. New car prices were flat and maybe those price
increases will be delayed until models – the 2026 models start
hitting the lot. That would be September or later. And we didn't
actually; I said apparel. Apparel was up stronger last month. It
really wasn't up all that much this month. So, the CPI data for
July corroborated the view that the inflation pass through is
happening.
Where I think it didn't answer the question is how much of it are
we going to get and should we expect a lot of it to be front
loaded? Or is this going to be a longer process?
Michael Zezas: Got it. And then, does that
mean that tariffs aren't having the sort of aggregate impact on
the economy that many thought they would? Or is maybe the
composition of that impact different? So, maybe prices aren't
going up so much, but companies are managing those costs in other
ways. How would you break that down?
Michael Gapen: We would say, and our view
is that, yes, you know, we have written down a forecast. And we
used our modeling in the 2018-20 19 episode to tell us what's a
reasonable forecast for how quickly and to what degree these
tariffs should show up in inflation. But obviously, this has been
a substantial move in tariffs. They didn't start all at once.
They've come in different phases and there's a lot of lags here.
So, I just think there's a wide range of potential outcomes here.
So, I wouldn't conclude that tariffs are not having the effect we
thought they would. I think it's way too early and would be
incorrect to conclude, just [be]cause we've had relatively modest
tariff pressures in June and July, inflation that we can be
sanguine and say it's not a big deal and we should just move on.
Michael Zezas: And even so, is it fair to
say that there's still plenty of evidence that this is weighing
on growth in the way you anticipated?
Michael Gapen: I think so. I mean, it's
clear the economy has moderated. If we kind of strip out the
volatility and trade and inventories, final sales to domestic
purchasers 1.5 in the first quarter. It was 1.1 in the second
quarter, and a lot of that slowdown was related to spending by
the consumer. And a slowdown in business spending. So that that
could be a little more, maybe about policy uncertainty and not
knowing exactly what to do and how to plan.
But it also we think is reflected in a slowdown, in the pace of
hiring. So, I would say, you got the policy uncertainty shock
first. That also came through the effect of the April 2nd
Liberation Day tariffs, which probably caused a freeze in hiring
and spending activity for a bit. And now I would say we're moving
into the part of the world where the actual increase in tariffs
are going to happen. So, we'll know whether or not firms can pass
these prices along or not. If they can't, we'll probably get a
weaker labor market. If they can, we'll continue to see it in
inflation.
But Mike, let me ask you a question now. You've had all the fun.
Let me turn the table.
Michael Zezas: Fair enough.
Michael Gapen: How much does it matter for
you or your team, whether or not these tariffs are pushing prices
higher? And/or delaying cuts from the Fed. How do you think about
that on your side?
Michael Zezas: Yeah, so this question of
composition and lags is really interesting. I think though that
if the end state here is as you forecast – that we'll end up with
weaker growth, and as a consequence, the Fed will embark on a
substantial rate cutting program. Then the direction of travel
for bond yields from here is still lower. So, if that's the case,
then obviously this would be a favorable backdrop for owners of
U.S. treasury bonds.
It's probably also good news for owners of corporate credit, but
the story's a bit trickier here. If yields move lower on weaker
growth, but we ultimately avoid a recession, this might be the
sweet spot for corporate credit. You've got fundamental strength
holding that limits credit risk, and so you get performance from
all in yields declining – both the yield expressed by the
risk-free rate, as well as the credit spread.
But if we tipped into recession, then naturally we'd expect there
to be a repricing of all risk in the market. You'd expect there
to be some expression of fundamental weakness and credit spreads
would widen. So, government bonds would've been a better product
to own in that environment.
But, of course, Michael, we have to consider alternative outcomes
where yields go higher, and this would turn into a bad
environment for bond returns that would appear to be most likely
in the scenario where U.S. growth actually ticks higher,
resetting expectations for monetary policy in a more hawkish
direction.
So, what do you think investors should watch for that would lead
to that outcome? Is it something like an AI productivity boom or
maybe something else that's not on our radar?
Michael Gapen: Yeah, so I think that is
something investors do have to think about; and let me frame one
way to think about that – where ex-post any easing by the Fed as
early as September might be retroactively viewed as a policy
mistake, right? So, we can say, yes, tariffs should slow down
growth and maybe that happens in the second half of this
year.
The Fed maybe eases rates as a pre-emptive measure or risk
management approach to avoid too much weakness in the labor
market. So even though the Fed is seeing firming inflation now,
which it is. It could ease in September, maybe again in December
[be]cause it's worried about the labor market. So maybe that's
what dominates 2025. And, and like you said, perhaps in the very
near term, continues to pull bond prices lower.
But what if we get into 2026 and the tariff effect or the tariff
drag on growth fades, and the consumer begins to accelerate. So,
we don't have a recession, we just get a bit of a divot in growth
and then the economy recovers. Then fiscal policy kicks in,
right?
We don't think the One Big, Beautiful Bill act will provide a lot
of stimulus, but we could be wrong. It could kickstart animal
spirits and bring forward a lot of business spending. And then
maybe AI, as you said; that could be a combining factor and
financial conditions would be very easy in that world, in part –
given that the Fed has eased, right?
So that that could be a world where, you know, growth is modest,
but it's firming. Inflation that's moved up to about 3 percent or
maybe a little bit higher later this year kind of stays there.
And then retroactively, the problem is the Fed eased financial
conditions into that and inflation's kind of stuck around 3
percent. Bond yields – at least the long end – would probably
react negatively in that world.
Michael Zezas: Yeah, that makes perfect
sense to us. Well, Michael, thanks for taking the time to talk
with me.
Michael Gapen: Thanks for having me on,
Mike.
Michael Zezas: And to our audience, thanks
for listening. If you enjoy Thoughts on the Market, please leave
us a review and tell your friends about the podcast. We want
everyone to listen.
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