Weekly global economic update
What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Tariff proposals remain the biggest economic news
- Tariff uncertainty continues. US President Trump recently said that his administration might impose a 25% tariff on imports of automobiles as well as pharmaceuticals and semiconductors. He said that the tariff rate could go “substantially higher” than 25%, and the possibility that tariffs could go far beyond the initial 25% is meant to encourage companies to shift operations to the United States. He did not offer a date for implementation. This follows his decision to impose a 25% tariff on imports of steel and aluminum, set to take effect in March.
Regarding trade in automobiles, the potential tariff on automotive imports comes at a time when the United States is still considering a 25% tariff on imports from Canada and Mexico. If that happens, it will likely disrupt the North American automotive market, which involves highly integrated and efficient supply chains across three countries. It is well known that inputs often cross a border within North America several times before a finished automobile is ready.
Thus, tariffs within the region would likely lead to a profound redesign of supply chains, potentially involving shifting processes from Mexico and Canada to the United States. Costs would rise, leading to higher prices and weaker demand. Under this scenario, imported automobiles from Europe and Asia could have a competitive advantage. Thus, a decision to impose tariffs on all automotive imports would remove the advantage for European or Asian car producers. Yet a tariff on all automotive imports would lead to higher costs of assembly within the United States (as imported parts become more expensive) and higher retail prices of cars. That, in turn, would dampen demand. Uncertainty as to whether any of these tariffs will happen could have a chilling effect on new investment.
Meanwhile, it is reported that Japanese automotive companies are starting to plan on a world in which they face steep tariffs in the United States. Those that operate factories in the United States must now prepare for US tariffs on imported steel and aluminum. Moreover, if the United States imposes tariffs on all imported automobiles and part, these companies will have to contend with that as well. Finally, some of these Japanese companies operate in Mexico and Canada, participating in regional integrated supply chains. Tariffs on Mexico and Canada would be disruptive to this system. One executive of a Japanese car company operating in the United States said that “we are now trying to bring production in Mexico and Canada to the United States by the end of February as much as possible.” Ultimately, decisions about production and investment location will depend, in part, on the mix of tariffs.
Regarding pharmaceutical imports, tariffs would boost prices, potentially leading to higher health insurance costs. While the goal is to cause a reshoring of manufacturing processes, it is likely that this process would take time. Moreover, it would certainly involve higher costs.
Finally, tariffs on semiconductors would be meant to encourage reshoring of chip fabrication. This process is already under way due to the subsidies provided through the Chips Act. The current US administration wants to end those subsidies and, instead, use tariffs to encourage that process. Either way, the process takes a lot of time and is hugely expensive. Consequently, tariffs will initially lead to much higher costs for US companies that directly import semiconductors. However, a lot of semiconductors that are fabricated outside the United States are sent to other non-US locations to be included in assembly of phones and computers. The administration has not yet talked about imposing tariffs on imported products that have semiconductors embedded in the products.
US Fed signals cautious approach, driven by tariff uncertainty
- In late January, the Federal Open Market Committee (FOMC) of the Federal Reserve, which is the principal policymaking arm of the Fed, met to determine interest rate policy. At that time, the FOMC kept the benchmark interest rate unchanged, which was not a surprise. Recently, the minutes of that meeting were released, which provide more information about the thinking of the FOMC members.
Importantly, the minutes state that “a majority of participants observed that the current high degree of uncertainty made it appropriate for the committee to take a careful approach in considering additional adjustments to the stance of monetary policy.” Indeed, this is a period of considerable uncertainty about the direction of economic policy. This includes uncertainty about when and by how much tariffs will be introduced. It also includes uncertainty about what the US Congress will do about taxes and spending, especially at a time when the budget deficit is large and likely to grow.
Notably, the FOMC did engage in a discussion about the potential impact of tariffs. Considering that a majority of US imports are intermediate goods, the minutes said that “business contacts in a number of districts had indicated that firms would attempt to pass on to consumers higher input costs arising from potential tariffs.” The Fed also indicated that, aside from potential tariffs, immigration policy and the strength of consumer balance sheets are both factors that could add to inflationary pressure. As such, the minutes state that the FOMC “would want to see further progress on inflation before making additional adjustments to the target range for the federal funds rate.” Still, the committee did acknowledge that considerable progress on inflation has already taken place.
The Fed also said that it could be difficult to distinguish between underlying inflation and inflation temporarily generated by the imposition of tariffs. Moreover, tariffs would reduce consumer purchasing power, thereby potentially weakening demand in the economy. That, in turn, could be disinflationary.
Also, the members noted that there are factors unrelated to trade and migration that could suppress inflation. These include continuing increases in labor productivity as well as a likely slowdown in the growth of demand for labor. Indeed, the minutes state that “labor market conditions were unlikely to be a source of inflationary pressure in the near future.” Still, the committee said that the balance of risks is in the direction of higher inflation.
As of very recently, the futures market’s implied probability of one or two rate cuts this year was 66%, with a 16% chance of no rate cut. Investors evidently believe that the relative strength of the US economy combined with tariff uncertainty means either gradual or no easing of monetary policy this year.
US equity price performance lags Europe
- Since the start of the new year, European equities have substantially outperformed US equities. How can we explain this? Equity prices are meant to reflect investor expectations of future earnings, discounted at an appropriate interest rate. One explanation is that expectations of interest rates have shifted, with investors now expecting almost no easing of monetary policy in the United States compared to significant easing in Europe. This directly affects the discount rate applied to expected future earnings. Plus, expectations of lower European rates suggests that there will be a rebound in economic growth while higher rates in the United States might slow economic growth.
Another explanation for the divergence of United States and European equity performance is that, since it became clear that tariffs are now the principal economic policy tool of the US government, investors have soured on the outlook for the US economy. Investors are likely concerned that tariffs will be inflationary, thereby leading to a tightening of monetary policy; that tariffs will hurt the competitiveness of US companies that rely on imported intermediate goods; that tariffs will undermine consumer purchasing power in the United States; and that the threat of tariffs could have a chilling effect on business investment.
Also, one of the star performers of European equity markets has been the defense sector. Defense-related shares in Europe have performed far better than the so-called Magnificent Seven in the United States. Evidently, investors are betting that the changing attitude of the United States to Europe means that European governments will have to boost their own defense spending significantly as they will no longer be confident about US protection from Russia. Indeed, European leaders have had discussions about creating a combined force outside the NATO umbrella. European leaders are expected to announce the details of this after the upcoming German election. They are reported to be concerned that, if the US forces Ukraine into a bad deal, Russia will be emboldened to threaten other European countries.
Meanwhile, the expectation that European governments will boost defense spending has led to a rise in bond yields in several European countries. The yield on Germany’s 10-year bond is up 10 basis points recently. Yields are also up in the United Kingdom, France, Italy, and Spain. Yields are not up, however, in Poland, which long ago boosted its defense spending significantly.
Will European equities continue to outperform US equities? No one knows. However, if Europe’s pessimism about geopolitical events (tariffs, Ukraine, Russia, migration, the rise of far-right populist parties) is justified, then it seems reasonable to expect a period of economic uncertainty in Europe at the very least. That, in turn, implies weaker equity market performance. On the other hand, if European policymakers decide to act decisively to offset the withdrawal of the United States from European affairs, it could have a stimulative impact on European economic activity. That, in turn, could boost equity prices.
Japanese growth strong, fuelled by exports
- In the fourth quarter of 2024, Japan’s economy expanded from the previous quarter at an annualized rate of 2.8%. This is extremely strong and is certainly most welcome, especially as it is the third consecutive quarter in which growth was strong. This followed a period in which the economy contracted in two of the previous three quarters.
Growth was largely fueled by a very big increase in exports of both goods and services. Strong tourist spending was responsible for strong exports of services. Imports were down sharply, meaning that net trade had a large positive impact on economic growth. Meanwhile, capital investment by business was up relatively strongly while consumer spending was up only very modestly. This followed much stronger growth of household spending in the previous quarter.
While there was much to celebrate about the strong quarter, the relative weakness of domestic demand was disappointing. Strong export growth might have been due, in part, to frontloading in anticipation of potential US tariffs. If the domestic economy remains weak, this will surely be cause for concern on the part of the Bank of Japan, which has been tightening monetary policy to fight inflation. Rising food prices have led the government to release rice from its stockpiles to suppress prices. The BOJ wants to suppress inflation but is likely to be cautious given the weakness of demand.
In response to the news about real GDP, the value of the yen appreciated. Yet there has been considerable downward pressure on the yen due to a tight monetary policy by the US Federal Reserve and due to the threat of US tariffs. Japanese exports accelerated sharply in January. When measured in yen, exports were up 7.2% in January from a year earlier, the strongest rate of growth since July 2024. It is likely that the strength of exports partly reflected frontloading of exports to the United States in anticipation of tariffs. While the US administration has not talked much about tariffs on Japanese imports, it has discussed tariffs on products that Japan produces such as automobiles.
- Japanese exports to the United States were up 8.1% in January from a year earlier while exports to China were down 6.2%. However, the latter figure might be misleading as exports to Hong Kong were up 13.7%. Meanwhile, exports were up 12.7% to Taiwan, up 6.1% to South Korea, up 15.6% to Southeast Asia, but down 15.1% to the European Union. A lot of what goes to Taiwan and South Korea are intermediate products used to produce final high-tech products that are exported to the United States. As for products, Japanese exports were up 11.4% for automobiles but up only 2.2% for semiconductors. Automobiles account for 28% of Japanese exports to the United States.
Japanese imports were up 16.7% in January versus a year earlier, the strongest growth since July 2024. In part, the strength of imports likely reflected importing components that are used to produce exportable products. And, of course, exports grew strongly in January. Notably, imports were up 18.3% from China but only 5.3% from the United States. Among the categories of imports that saw big increases were computers (up 51.2%), machinery (up 46.9%), electrical machinery (up 18.2%), and clothing (up 19.6%).
The strength of exports in Japan will contribute to economic growth in the first quarter. However, frontloading in January suggests that export growth could decelerate going forward, especially if tariffs are implemented. Thus, Japan still needs stronger domestic demand to drive economic growth.
Week of February 17, 2025
US inflation accelerates. Should the Fed worry?
- Inflation in the United States accelerated more sharply than anticipated in January. The question now is whether this is a one-off event or the continuation of a trend. If the latter, it will create a new conundrum for the Federal Reserve as it deliberates on monetary policy. It also raises questions about the current government policies that could exacerbate an already difficult situation. First, let’s look at the data.
The US government reported that, in January, the consumer price index (CPI) was up 3% from a year earlier, the biggest annual increase since June 2024. Prices were up 0.5% from December to January, the biggest monthly gain since August 2023. In part, the strong numbers reflected a sharp rise in energy prices. When volatile food and energy prices are excluded, core prices were up 3.3% in January versus a year earlier. In every month since June, annual core inflation was either 3.2% or 3.3%. Thus, annual core inflation has been persistent and well above the Federal Reserve’s target of 2%. Meanwhile, core prices were up 0.4% from December to January, the biggest monthly gain since March 2024. Thus, core inflation has accelerated.
What is happening? It helps to look at the details. The press made much of the massive increase the price of eggs. Indeed, egg prices were up 53% from a year earlier and up 15.3% from the previous month. This has been attributed to an outbreak of avian flu. Yet eggs account for only 0.17% of the CPI. Thus, this hardly explains the acceleration in inflation.
One possibility is that sellers of durable goods, many of which are imported or are made of imported components, boosted prices in anticipation of tariffs. Indeed, the index of prices of durable goods increased 0.4% from the previous month, the second highest monthly increase since April 2023.
Another possibility is that strong consumer demand, combined with a tight labor market, boosted prices of labor-intensive services. The index of prices of services was up 0.5% from December to January, the biggest monthly gain since March 2024. Service inflation has been high and persistent even as overall inflation has fallen in the past year. Now it appears to be accelerating.
Also, inflation in the past few years was boosted by the rising cost of housing. When housing is excluded, inflation has been relatively low for a while—but that is starting to change. In January, the CPI excluding housing was up 0.5% from December to January, the biggest monthly gain since August 2023. This indicator was up 2.2% from a year earlier, the biggest annual gain since April 2024. Thus, it appears that underlying inflation is now moving in the wrong direction.
In response to this news, bond yields jumped sharply while equity prices fell on expectations of tighter monetary policy. The value of the US dollar increased. Futures markets’ implied probability of one interest-rate cut this year increased while the probability of two rate cuts decreased. This was due to the assumption that inflation will be higher than previously anticipated.
Meanwhile, there continues to be pressure on the Federal Reserve to explain how the policies of the new administration will influence its deliberations. President Trump has called for sharp interest-rate cuts despite an acceleration in inflation. Yesterday, Fed Chair Powell said that the Fed will “focus on the data” as it decides what to do and will not be influenced by politics. He said, “We’ll make better policy, we’ll keep inflation lower, if we just focus on doing our job and stay out of politics, stay out of elections and don’t try to favor or hurt any political party, or any political filter and just try to focus on the data. If we start putting up political filters, we’ll be less effective at our already quite difficult job.”
Regarding the impact of administration policies, especially tariffs, on inflation, Powell said that “it really does remain to be seen what tariff policies would be implemented. It would be unwise to speculate when we really don’t know. We see proposals, but it’s so hard to say what will happen. It’s really not just tariffs. It’s tariffs, immigration, fiscal policy, and regulatory policy. We’ll try to make sense of it and do what’s right for monetary policy.”
The conventional wisdom is that tariffs will be inflationary. Yet there is a different perspective. Richard Clarida, a former vice chair of the Fed, wrote in the Financial Times that, although imposition of a tariff will cause a one-off increase the price of a product, it will also reduce consumer purchasing power, thereby dampening demand in the economy. That, in turn, could ultimately be disinflationary. More importantly, Clarida argues that trade policy uncertainty can have a negative impact on business investment, thereby slowing economic growth and reducing inflationary pressure.
However, Clarida acknowledges that today’s situation is different than when the first Trump Administration imposed tariffs in 2018. Back then, there was little inflationary pressure and no inflationary psychology. Thus, when tariffs were introduced, inflation did not rise but demand in the economy faltered in 2019, leading the Fed to loosen monetary policy. Today, after a period of stunning inflation, with inflation not yet beaten, and with an inflationary psychology likely intact, tariffs could ignite more inflation—at least temporarily. Still, they would also weaken demand.
The latest on the trade environment
- The United States is imposing a 25% tariff on all imports of steel and aluminum, regardless of the country of origin. The biggest suppliers of steel and aluminum to the United States are, in order, Canada, China, and Mexico, which are also the three largest trading partners of the United States. Canada is, by far, the largest supplier to the United States of aluminum. These three countries account for almost half of US imports of these two products. South Korea, Germany, and Brazil are also major suppliers. During the first Trump Administration, the United States imposed a 25% tariff on steel and aluminum, but ultimately provided an exemption for imports from several countries including Canada and Mexico.
The initial announcement of the tariffs led to an increase in metals prices and a decline in the equity prices of non-US steel and aluminum producers. Shares of US producers appreciated. The US imports about 23% of the steel consumed and about half of the aluminum consumed.
The European Union (EU) said that it will retaliate against the US tariffs. These tariffs are seen as potentially devastating to Europe’s steel industry. The EU has already proposed a 50% tariff on 4.8 billion euros of imports from the United States, including products such as whiskey, motorcycles, motorboats, and some steel and aluminum products. A final vote by the EU remains to take place. The EU Trade Commissioner said that “the EU sees no justification for the imposition of tariffs on our exports, which is economically counterproductive—especially given the deeply integrated production chains established through our extensive transatlantic trade and investment ties.” He proposed that there be negotiations. Meanwhile, the UK government said it will not retaliate. It hopes to avoid a trade war with the United States and enhance ties in technology, professional services, and financial services.
- US President Trump ordered the US government to develop a plan for reciprocal tariffs, with the goal of reducing the US trade deficit. Reciprocal tariffs would mean that, if another country imposes a higher tariff on US imports than the United States imposes on that country’s imports, then the United States should boost its tariffs accordingly. Moreover, reciprocity will apply not only to tariffs but also to VAT (value-added tax) rates. That is, President Trump wants US tariffs to offset the fact that other countries have higher consumption taxes than the United States. However, VATs are imposed on all goods, not just imported goods. As such, imported goods do not face a competitive disadvantage as a result of facing a VAT.
The President warned that many countries are at risk from his reciprocal tariff policy, including Japan, the EU, Brazil, and India. Trump said that “I’ve decided, for purposes of fairness, that I will charge a reciprocal tariff, meaning whatever countries charge the United States of America. In almost all cases, they’re charging us vastly more than we charge them, but those days are over.”
What does the tariff situation entail? The average effective tariff rate that some countries impose on imports from the United States is often different than the tariff imposed by the United States. Yet this is not a simple matter. For example, the average effective tariff that EU nations impose on imports from the US is 2.7% while the average effective tariff the US imposes on EU imports is 2.2%. On the surface, this seems like a trivial difference. However, the tariffs vary by product. For example, the EU imposes a 10% tariff on imports of US vehicles while the US tariff on EU vehicles is 2.5%. Thus, the President has threatened to impose a 10% tariff on vehicles from the EU. In response, some EU officials have suggested cutting the EU tariff to match that of the United States. If, however, the United States boosts the tariff on European vehicles to 10%, this will likely lead to higher prices for European vehicles sold in the United States.
The situation regarding Japan is interesting. Japan’s effective tariff on imports from the United States is only 1.9% while the US tariff on Japanese imports is 1.4%—again, not a big difference. However, there are big differences when it comes to specific products. For example, Japan’s tariff on imports of US rice is 204.3%. Japan has long protected its rice farmers. The tariff on imported US meat is 23.3%. The US has high tariffs on sugar and on dairy products. It too has long protected sugar and dairy farmers. On the other hand, Japan’s tariff on imports of US automobiles is zero, while the US tariff on Japanese cars is 1.9%. Given the US call for reciprocity, does this mean that the United States should lower its tariff on Japanese cars? That is not likely. In any event, the United States has not been clear as to whether reciprocity will involve average tariffs or tariffs on specific products.
With respect to China, the United States has already imposed substantial tariffs on imports from China, first in 2018 and now again in 2025. Although China has engaged in modest retaliation, the reality is that China’s average effective tariff on US imports is now lower than average US tariffs on China. Thus, under a reciprocal approach, the United States should lower tariffs on Chinese imports. Yet the US has offered other reasons to impose higher tariffs on China.
Moreover, the recent 10% tariff on Chinese imports imposed by the United States is far less than the 60% tariff that was discussed during the election campaign. Plus, since the first set of tariffs were imposed in 2018, trade relations have shifted dramatically. As recently as 2021, Chinese imports accounted for roughly 21% of US imports. That figure dropped to near 14% in 2024. This reflects companies redesigning supply chains to avert US tariffs on Chinese imports. Thus, inbound US company investment into China has fallen sharply, offset by rising investment elsewhere.
Finally, some emerging countries are highly exposed to the reciprocity effort by the United States. For example, the average effective tariff on US imports is 12% for India, 7% for Brazil, and 5% for Vietnam. These countries might be compelled to lower their tariffs to avoid higher US tariffs.
Notably, President Trump acknowledged that this policy could boost inflation in the United States. He said that “prices could go up somewhat short-term. But prices will also go down. What will go up is jobs. The jobs will go up tremendously.” That assumes that US consumers will replace imported goods with domestically produced goods. It also assumes that US exports will not be harmed by higher costs or retaliatory tariffs.
- During the Biden Administration, the Chips and Science Act was used to provide subsidies to foreign semiconductor manufacturers that invested in the United States. The goal was to encourage diversification of semiconductor production to reduce excessive dependence on Taiwan and China. The Trump Administration is taking a different approach with the same goal. It wants to eliminate the financial incentives and, instead, place tariffs on imported chips.
The shift in policy is of particular concern in Taiwan where the world’s largest fabricator of semiconductors is located. It is currently making a huge investment in the United States with the help of US$6.6 billion in subsidies from the US government. If this subsidy is cut or withheld, it could affect the profitability of the investment, especially given that fabrication involves low margins. The high margins go to the customers that design the chips. There is also a geopolitical aspect to this situation. Taiwan is seen as strategically important to the United States given its role in producing high end chips. If this is dissipated, Taiwan might worry about the US commitment to its security.
Finally, it is not clear what impact tariffs will have on import flows. Most of the chips produced in Taiwan are sent to countries other than the United States where the chips are inserted into final products such as mobile telephones.
- In the months following the US election, there was a sharp rise in US bond yields and a sharp rise in the value of the US dollar against major currencies. This reflected investor expectations that a combination of tax cuts, tariffs, and immigration restrictions would boost inflation and lead the Federal Reserve to ease monetary policy more gradually if at all. Since mid-January, however, bond yields have fallen and the value of the dollar has fallen or stabilized, especially against the Japanese yen, the British pound, the Canadian dollar, and several emerging market currencies. Why is this?
There are several possible explanations. First, many of the proposed tariffs have yet to be implemented and there is now uncertainty about the future trajectory of tariffs. Rising tariffs generally lead to a higher-valued currency. Thus, less certainty about tariffs implies a lower-valued dollar. Second, investors might fear that tariffs will slow economic growth by reducing consumer purchasing power and hurting export competitiveness, thereby dampening inflationary pressure. Moreover, it seems less likely than previously that there will be tax cuts which would both boost growth and potentially be inflationary. Consequently, bond yields have fallen and futures markets’ implied probability of two interest rate cuts in 2025 has increased from a month ago. This, in turn, has influenced the value of the dollar.
Week of February 10, 2025
More on trade and tariffs
- Leaders in the European Union (EU) are worried that the United States will impose tariffs on imports from the EU. Consequently, they are working on a strategy for responding to any potential US action. There appears to be a consensus that the best way to hit the United States, and potentially avert tariffs, is to target digital services rather than imports of goods. That is, the EU would use its “anti-coercion instrument” (ACI), which was developed several years ago to deal with China.
The ACI is meant to allow the EU to place restrictions on services trade if the other party has used restrictions on goods trade to coerce the EU into changing a policy. There are currently two areas where the EU is concerned that the United States might attempt to coerce the EU or a member of the EU. These are the US demand that Denmark surrender Greenland to the US, and the US demand that the EU curtail enforcement actions against US technology companies.
Among the ways that the ACI could be implemented are revoking intellectual property protections, restricting inbound foreign investment, or restricting access to particular markets. One complaint from the United States is that it has a trade deficit with the EU in goods. Yet the United States has a trade surplus with the EU in services. Taking on the US tech industry would be a way for the EU to undermine the US surplus.
Still, experience suggests that, if Europe wants to avoid a trade war with the United States, it should be prepared to offer the US administration something it wants.
- Although the United States delayed tariffs on Mexico and Canada, it allowed tariffs on China to go into effect. All imports from China are now facing a 10% tariff in addition to already existing tariffs, most of which were imposed during the first Trump Administration. About US$450 billion in annual imports from China are expected to be affected. More than half of US imports from China are intermediate goods used by US companies to produce final goods and services. Thus, the new tariffs will add costs for many US companies. While there will likely be efforts to find alternative sourcing, that will take time and might not be possible in all cases. For China, which has seen strong growth in exports to the United States in recent months (in part due to frontloading in anticipation of tariffs), the new tariffs will likely mean a deceleration in export volume, thereby hurting economic growth.
China responded to the US tariffs with limited retaliatory tariffs of 10% to 15% on products such as liquified natural gas (LNG), crude oil, coal, farm equipment, and some types of automobiles. The Chinese tariffs will target only about 10% of imports from the United States. As such, this action is relatively restrained. In addition, China will place new restrictions on exports of rare earth minerals. Finally, China’s government opened new anti-competitive investigations of some US technology companies.
The relatively restrained response of China to US tariffs suggests that China hopes to reach an accommodation with the United States. Indeed, the presidents of the United States and China are set to speak by telephone soon. Moreover, President Trump has expressed the hope that China can play a role in ending the Ukraine-Russia conflict by putting pressure on its Russian ally.
Meanwhile, it has been reported that Chinese companies intend to accelerate plans to invest in other countries to produce goods for export to the United States. This diversion of trade has already been taking place on a large scale for the past decade. Indeed, China’s share of US imports has fallen sharply in recent years. Instead, China has exported components to factories in other countries that produce final goods for export to the United States. While this has mostly involved Southeast Asia and, to a lesser extent, Mexico, it is likely that Chinese companies will invest elsewhere, such as in the Middle East. This enables production for export to the United States as well as for new markets. On the other hand, the US Administration has complained about Chinese products coming from other countries, especially from Mexico. Thus, Chinese companies that assemble goods outside of China remain at risk of facing US trade restrictions.
- In the fraught trading relationship between the China and the United States, China has some leverage. It’s dominance in the global market for rare earth minerals allows it to respond to US trade restrictions in a way that can truly hurt US business. Indeed, following the US imposition of a 10% tariff on all imports from China, China intensified its restrictions on the exporting of rare earth minerals, in addition to imposing retaliatory tariffs.
The reality is that China is home to about 60% of the reserves of rare earth minerals and is responsible for about 90% of the processing or refining of those minerals. In 2024, in response to US restrictions on trade in high-tech products, China restricted exports to the US of antimony, gallium, and germanium. Last week, China added five more minerals to the list: tungsten, tellurium, bismuth, molybdenum, and indium. These minerals are important for producing high technology products, clean energy products, and defense industry products. Shortages of such minerals could curtail or disrupt production in the United States.
In recent years, the United States has undertaken efforts to diversify the supply of rare earth minerals to reduce dependence on China. Central Asia is seen as a particularly promising region, although some Central Asian countries remain close to Russia, which has poor relations with the United States. In addition, Ukraine has key minerals. The United States has suggested greater access to Ukrainian minerals in exchange for military support in the war against Russia. The problem is that, although new investments are taking place, it takes a long time to reach fruition, possibly as much as a decade. In the interim, dependence on China continues, thereby potentially disrupting US technology development.
US employment and productivity trends
- In the United States, employment continued to grow at a healthy pace in January, although the pace decelerated from previous months. Meanwhile, the unemployment rate fell. The government produces a report on employment based on two surveys: One is a survey of establishments; the other is a survey of households. Let’s look at the data.
The first thing to know is that, in January, the government revised data from the past two years based on new information. The government downwardly revised establishment job growth for the 12 months ended in March 2024 by 589,000. This was a smaller revision than many economists had anticipated. In addition, the household data was revised based on new immigration data. It found that there are currently two million more people employed than previously estimated, mainly due to strong immigration. The government also found that the employment-to-population ratio for working-age people (16 to 64) is now higher than just prior to the pandemic. Yet the employment-to-population ratio for all people over 16 is lower, due to the aging of the population.
Next, let’s look at the establishment survey data. It found that, in January, 143,000 new jobs were created. That is a substantial deceleration from the upwardly revised job growth in November (261,000) and December (307,000), but still more than the underlying growth of the working-age population.
By industry, there was essentially no growth for construction, mining, and manufacturing. All the growth was in private sector services or government. There was a big increase for retailing (up 34,300), mostly at big box stores such as Walmart and Costco. The government seasonally adjusts the retail numbers, assuming a big drop in employment after the holiday season. The reported increase suggests few layoffs in January. That, in turn, might indicate less holiday hiring in November and December than usual. Questions have arisen as to whether the seasonal adjustments, based on historical patterns, are no longer up to date given the massive shift to online shopping.
Also, there was a decline in employment in professional and business services, mainly in consulting and temporary work. There was a big increase in health care (up 43,700) and in government (up 32,000). There was a surprising decline in employment in leisure and hospitality. Most other industries saw only modest changes in employment.
Also, the establishment survey includes data on wages. It found that average hourly earnings in January were up 4.1% from a year earlier, the same as in December and October. The labor market remains tight. This partly reflects the aging of the population as more people retire. In addition, there is concern that immigration restrictions and deportations could exacerbate the tightness of the labor market.
Finally, the separate household survey found that, from December to January, the labor force participation rate increased, the employment-to-population ratio increased, and the unemployment rate fell to 4%, down from 4.1% in the previous month.
In response to the jobs report, bond yields increased modestly. Investors likely saw the moderately favorable jobs report as justifying the Fed’s decision to slow the pace of monetary easing.
- In the United States, one of the principal reasons for strong economic growth in 2024 was a sharp rise in labor productivity (output per hour worked). Recently, the government reported the final numbers for 2024 and they were very strong, although productivity growth did decelerate in the fourth quarter. Moreover, productivity gains not only boosted growth. They also helped to suppress inflation. That is, businesses were able to boost wages without raises prices commensurately as they were getting more out of each worker. This, in turn, allowed the Federal Reserve to start easing monetary policy in late 2024 even though the economy remained very strong while inflation was not fully defeated. Let’s look at the details.
In 2024, labor productivity was up 2.3% from the previous year, the fastest such growth since 2020. In that year, productivity soared by 5.4%. This was mainly due to the dismissal of large numbers of low-productivity service workers during the pandemic. This artificially boosted average productivity of the remaining workforce. The strong growth in 2024, however, was not artificial. Rather, it reflected the impact of a large amount of business investment in labor-saving and labor-augmenting technologies. This was undertaken, in part, to address a persistent labor shortage that was driving up labor costs.
Notably, the rise in labor productivity in 2024 was largely driven by services than manufacturing. Indeed, the government reported that labor productivity in manufacturing increased only 0.3% in 2024, indicating that services productivity soared. For the economy as a whole labor productivity in the fourth quarter of 2024 was 9% higher than just prior to the pandemic, while manufacturing productivity was only 1% higher.
In the fourth quarter, productivity growth decelerated from the previous quarter, although it continued to rise at a healthy rate. The principal uncertainty now is whether productivity growth will continue in 2025. If it does, it will have a positive impact on growth and help to suppress inflation. However, if productivity growth stalls, then the opposite will be true. Given the amount of investment that has been taking place in the past year, especially involving implementing new technologies, it seems reasonable to expect a continued rise in productivity.
Global economic relations are changing in anticipation of US tariffs
- Since 2017, when the first Trump Administration began, the US share of global trade has been declining, even as the US share of global GDP has increased in line with relatively strong US economic growth. Moreover, the US share of global equity valuation has soared, a reflection of global investor confidence in the profitability of innovative US companies. Meanwhile, non-US trade has been growing and becoming more liberalized, as countries sign trade agreements.
Going forward, one question that arises is whether a further withdrawal of the United States from the global trading system will have an adverse impact on US economic growth. Trade has traditionally been a major source of economic growth for many countries. Export growth boosts employment and real GDP. Plus, export opportunities create the possibility of economies of scale, thereby driving greater efficiency. Meanwhile, growth of imports boosts competition, thereby requiring domestic producers to be more efficient and competitive. This requirement stimulates innovation and, consequently, productivity growth. Finally, past episodes of higher tariffs and reduced trade volumes have generally been accompanied by periods of slower economic growth.
From the late 1940s until 2008, global trade was characterized by periodic episodes of trade liberalization, often on a multilateral basis but sometimes involving bilateral or regional trade deals. This liberalization meant reduced barriers to trade, including lower tariffs and fewer nontariff barriers such as quantitative restrictions, regulatory hurdles, or restrictive government procurement rules. As barriers came down, global companies increasingly felt comfortable designing highly efficient global supply chains meant to achieve low costs and high speed. This process especially accelerated following China’s accession to the World Trade Organization at the start of this century.
Meanwhile, it is not simply the threat of tariffs that is changing the world trading system. Previous actions by the US government under both the Trump and Biden administrations have led to changed supply chain designs and trade patterns. Since 2017, global trade has remained a steady share of global GDP. However, US trade as a share of US GDP declined while trade as a share of national GDP increased for most other major countries. Not only did the United States impose trade restrictions, but also walked away from potential trade deals with the European Union and with Pacific Basin countries.
Since 2017, we have seen numerous instances of trade liberalization, as countries sought to reduce the risk of exposure to changes in US trade rules. The European Union negotiated eight free trade agreements while China negotiated nine such agreements. Additional agreements remain under negotiation.
What is happening now in global trading relations as the world awaits US decisions on tariffs? Although many government leaders are preparing to deal with higher US trade barriers, perhaps through retaliation, they are also rapidly seeking to expand trade with countries other than the United States. For example, the European Union has recently finalized a trade deal with a group of South American countries (Mercosur), updated a deal with Mexico, and reopened talks with Malaysia. The European Union is also engaged in trade talks with Australia and Indonesia. Plus, the EU trade minister said that many more countries have approached the European Union seeking to liberalize trade. Evidently, they are seeking to reduce their exposure to or dependence on the United States.
China, too, is moving in a similar direction. In recent years, it played a big role in fostering the Regional Comprehensive Economic Partnership, which entailed freer trade between a group of Asia-Pacific countries accounting for 30% of global GDP. Meanwhile, it is engaged in trade talks with several Latin American countries. The direction of outbound investment by Chinese companies has shifted from the United States and Europe to emerging markets. Trade flows will likely follow.
Despite all these efforts, the reality remains that the United States is the largest economy in the world and, by far, the largest importer. The US market is hugely attractive to global businesses and, with US economic growth likely to remain relatively strong, it will only become more attractive. Thus, the threat of tariffs is important. For now, there is simply uncertainty as the US administration has so far not implemented any new tariffs (as of this writing). Also, some government leaders are hoping to avert tariffs by initiating trade liberalization talks with the United States.
Aside from the impact of potential tariffs on trade and supply chain patterns, the threat of tariffs has already had an impact on financial markets. This has entailed higher US bond yields, changed expectations for Federal Reserve policy, and most importantly, a much higher-valued US dollar—although the dollar falls each time there is news suggesting less danger of tariffs.
The countries most vulnerable to such currency movements are emerging nations. For many, sharp currency depreciation can create new inflationary pressures. It can also boost the cost of servicing foreign currency–denominated debts. Thus, some emerging markets’ central banks have either started to or are considering tightening monetary policy. In addition, some emerging markets are more vulnerable to US tariffs than others. Countries with substantial trade with the United States—such as Mexico—are most vulnerable. This can affect the ability of governments and companies to raise funds through global markets. Countries that have low levels of external debt, strong domestic markets, and diversified trade are best-positioned to deal with the new environment. One country that has these attributes is India. China, by focusing on domestic demand and seeking to diversify its trade, is clearly attempting to reduce risk associated with exposure to the United States.
Finally, it is notable that the US government has focused almost exclusively on trade in goods. Yet, trade in services is hugely important and growing. The United States is not currently talking about imposing restrictions on trade in services, meaning that other countries can benefit from exporting services to the United States. Service trade is wide-ranging and includes tourism, offshored IT and professional services, insurance, other financial services, digital trade, and transportation. Some obstacles exist to service trade, especially in many emerging markets. Yet, the US market for services has been relatively open, generating growth in other countries. One example is the development of offshore services in India and other emerging markets.
The US economy remains strong
- The US government released data on fourth quarter real GDP growth recently. The economy grew a bit slower than investors had anticipated, but still grew at a healthy pace. Growth was fueled by a big increase in consumer spending, especially on durable goods. On the other hand, overall business investment fell as demand for equipment such as airplanes declined. Investor reaction to the report was muted as the data did not conflict with expectations. Let’s look at the details:
For all of 2024, real (inflation-adjusted) GDP was up 2.8% from 2023. This was very strong and was fueled by strong job growth combined with increases in labor productivity. The economy had grown 2.9% in 2023, so this was a very modest deceleration. However, it is worth recalling that, a year ago, many observers were predicting a recession in 2024 due to tight monetary policy. They were wrong.
In the fourth quarter of 2024, real GDP grew from the previous quarter at an annualized rate of 2.3%, the slowest growth since the first quarter of 2024. Real consumer spending was up 4.2%. This included growth of 12.1% for durable goods, 3.8% for nondurables, and 3.1% for services. The lion’s share of growth for durable goods came from motor vehicles and recreational goods and vehicles. The lion’s share of service growth came from health care. Real disposable personal income grew at a rate of 2.8% in the fourth quarter. As such, household spending continued to rise faster than income as consumers dipped into savings, saved less, and took on debt. Going forward, spending will likely be constrained by income.
Nonresidential fixed investment declined at an annual rate of 2.2%. This included a 1.1% decline in structures and a 7.8% decline in equipment. However, investment in intellectual property (software, research and development) increased 2.6% as businesses continued to purchase software. The sharp drop for equipment reflected a decline in demand for computers and transportation equipment. There had been strong purchases of aircraft in the previous two quarters. The easing of such purchases might explain the decline in the fourth quarter. As such, the decline in investment does not necessarily indicate a weakening of business demand. Also, there was a sharp decline in business inventories, which cut nearly 1 percentage point of growth from GDP. This likely reflected the impact of strong consumer demand. It also suggests that production and/or imports will accelerate in the coming months.
Trade made a negative contribution to real GDP growth in the fourth quarter. Both exports and imports of goods declined, while exports and imports of services grew strongly. The drop in goods imports is surprising, especially as there were reports of frontloading of imports in anticipation of tariffs. This preliminary report does not reflect imports in December. When those are added later, the first revision of GDP data might indicate growth of imports, which would subtract from real GDP growth.
Government purchases were up at a rate of 2.5%, which included a 3.3% gain for defense purchases and 3.1% for nondefense purchases. It is possible that the Biden administration frontloaded some expenditures in anticipation of a reversal by the incoming Trump administration. State and local government purchases grew more modestly at 2%.
When inventory changes and external trade are excluded, final sales to domestic purchasers were up 3.1%. This is a good indicator of underlying demand in the economy. It remained very strong in the fourth quarter. However, it decelerated from the 3.7% gain seen in the previous quarter.
Finally, the government measures both real and nominal increases in GDP and its components. The difference between the two is the change in prices. Importantly, the personal consumption expenditure deflator (PCE-deflator), which measures price changes for consumer spending, increased at an annual rate of 2.3% in the fourth quarter, indicating that headline inflation was very tame, although higher than the 1.5% rate recorded for the third quarter. When volatile food and energy prices are excluded, the core PCE-deflator was up at a rate of 2.5%, up from 2.2% in the third quarter. Although underlying inflation accelerated in the fourth quarter, it remains not far from the Federal Reserve’s 2% target.
Going forward, the US economy is likely to remain strong. However, some deceleration is likely. Consumer spending will probably grow more slowly, especially given the relatively high delinquency rate on credit card debt. Moreover, households have probably exhausted the excess savings they accumulated during the pandemic. In addition, there is a potential downside if significant tariffs are introduced. This could lead to increases in consumer prices that could undermine household purchasing power and weaken demand. Moreover, retaliatory tariffs from other countries could undermine US export growth. On the other hand, tax cuts and less intrusive regulation could have a positive impact on business investment.
US Federal Reserve keeps policy unchanged
- As expected, the Federal Open Market Committee (FOMC) of the Federal Reserve left the benchmark federal funds interest rate unchanged, according to its press release dated Jan. 29, 2025. The decision was unanimous. In his press conference, Fed Chair Powell said that the labor market has cooled and is no longer contributing to inflation. He also said that there has been progress on inflation. Still, he also said that labor market conditions are “solid” while inflation remains “elevated,” thus driving the policy decision. Powell further said that the interest rate remains above “neutral,” indicating that monetary policy remains tight. Yet, he also said that, given the strength of the economy, the Fed needn’t rush to adjust policy.
Following the Fed’s announcement, equity prices fell while bond yields rose. This suggests that investors found the FOMC commentary to be a bit hawkish. Equity prices were already down prior to the announcement, driven by sharp declines for several key technology companies. Investors had been shaken by news from China about artificial intelligence.
Also, the decision to keep interest rates on hold partly implies that the Fed lacks sufficient data to know the direction of inflation and employment. There remains uncertainty about the future direction of government policy levers that could influence both inflation and employment. These include tax rates, spending, regulatory decisions, tariffs, and immigration policy. Going forward, the Fed will likely be data-driven. As the Trump administration’s policy unfolds, this will provide the Fed with a road map. Indeed, Powell urged patience while the Fed waits to learn more about administration policy.
Eurozone economy stagnates while ECB cuts rates
- The European economy decelerated sharply in the fourth quarter. Real GDP was unchanged in the eurozone from the third to the fourth quarter. The last time there was no growth was in the fourth quarter of 2023. For the larger European Union, real GDP increased only 0.1% in the fourth quarter. For all of 2024, the eurozone’s GDP was up 0.7% from the previous year while EU GDP was up 0.8%.
By country, there was a disparity between Europe’s largest economies and the Mediterranean economies. Germany’s real GDP fell 0.2% from the third to the fourth quarter after experiencing modest growth in the previous quarter. France’s real GDP fell 0.1%. Real GDP in Italy was unchanged. On the other hand, Spain’s real GDP was up 0.8% (an annualized rate of 3.2%) while Portugal’s real GDP was up a stunning 1.5% (an annualized rate of 6.1%). Thus, the Iberian Peninsula is on fire, driven by tourism and immigration.
The weakness of the European economy was unexpected. It likely reinforced the view that the European Central Bank (ECB) will engage in monetary policy easing in the months to come. Indeed, the ECB cut its benchmark rate recently. European bond yields fell while equity prices increased, considering expectations of further rate cuts.
Regarding the ECB decision, the Governing Council cut all three policy interest rates by 25 basis points. The deposit facility rate has been cut from 4.5% in May to 2.75%. The ECB said that inflation is now on track to reach the 2% goal this year. It said that wage growth is easing, thereby reducing the impact of the labor market on inflation. ECB President Lagarde said that monetary policy remains restrictive but that continued easing of policy will reduce constraints on credit activity. She also said that the eurozone economy faces “headwinds,” but that rising real incomes and lower interest rates should help boost activity.
Lagarde said that manufacturing is weak but that this is offset by strength in services. She said that “consumer confidence is fragile, and households have not yet drawn sufficient encouragement from rising real incomes to significantly increase their spending.” She also said that there are downside risks to the economy, especially coming from potential external events. She said that “greater friction in global trade could weigh on euro area growth by dampening exports and weakening the global economy.” When asked whether US tariffs would be inflationary or deflationary for Europe, she said that she doesn’t know. However, she said that, either way, it would have a negative impact on the eurozone economy.
There is now a widespread expectation that the ECB will continue to cut interest rates throughout the year, likely faster than the US Fed cuts rates. This could result in further downward pressure on the value of the euro, which could be inflationary. On the other hand, it could boost the competitiveness of the eurozone’s exports.
