Tariffs noise hides positive inflation developments

Chief Economist Eugenio J. Alemán discusses current economic conditions.

Markets have been overwhelmed lately by the administration’s fast-paced and, many times, highly uncertain tariff measures. So much so, that nobody seems to have realized that recent inflation numbers have come in better than expected, and the prospects for more good inflation numbers in March and April have the potential to push the year-over-year PCE inflation rate to the Federal Reserve (Fed) target of 2.0%.

We know why markets and analysts are not giving this milestone a great deal of importance. That is, we see the same thing they are seeing: that the achievement of the inflation target in March and April will be short-lived, as base effects will take the rate of inflation higher than 2.0% during the rest of the year. On top of that, everybody, including us, is expecting tariffs to take inflation even higher when all the proposed tariffs are implemented.

However, where we disagree with other analysts, economists, and markets is in believing that underlying inflation continues to be benign. That is, the disinflationary trends we started to see two years ago or so remain in place, and other than a potential hiccup caused by the imposition of tariffs, those underlying disinflationary trends will remain in place.

Financial investment versus economic investment

Economic students learn early in their economist career that investment in the financial market is not the same thing as investment in the ‘real’ economy. Financial investments help channel funds into the economy and are the blood that irrigates the economy. However, this investment does not explain how firms invest in the real economy, which is what firms do when they decide to invest in machinery and equipment, in the construction of new plants, in the construction of new residences, etc. This is the heart of any economy, and this heart is still positive, as measured by the surge in construction spending in manufacturing plants we have observed during the last two years (see chart below).

Yes, it is true that ‘the blood that greases the heart is important’ but how many times have we seen the stock market decline by 5%, 10%, etc., and not trigger a recession? That is, large stock market declines do not necessarily trigger recessions. However, large real investment declines are the ones that trigger recessions. These real investment declines occur when firms and businesses sour on the prospects of the economy and start to reduce investment in machinery and equipment, construction of new plants, start getting rid of workers, etc. We have not seen anything like that during this cycle.

Financial markets have a relatively tangential influence on these decisions. Today, the CHIPS act, the IRA act, and the Infrastructure act are still providing the impetus we have seen in real investment in the economy. And as long as those investments continue, the economy will avoid a recession.

Financial markets respond to whims that, typically, are not related to what is happening in the real economy. Could a large fall in the stock market transform into an economic recession? Sure, it can. However, as we have said before, financial markets tend to correct several times during a year, but they seldom trigger a recession. We were expecting a correction to occur at the end of last year, but we are having it now. At the end of last year, financial markets were still running on the ‘sugar high’ of the Trump election and seem to have dismissed the potential implications of such a heavy pace of changes.

Today, markets are sending the Trump administration a signal that, while they approve of him, his policies are not in line with what markets were expecting. Will President Trump heed such signals? For now, he is saying that what he is doing is necessary and that the stock market is not his primary concern. We will have to wait and see if this is true but, for now, he seems to be okay with what is happening in the stock market.

We expect the noise from tariffs to start subsiding and for markets/decision makers to have increased certainty at the beginning of April, which is when the president would get the analysis from the Commerce Department on retaliatory tariffs. Until then, markets will remain volatile because if there is something they dislike more than more taxes (i.e., higher tariffs), it is uncertainty.

Changes to our economic forecast

We have adjusted our economic forecast to consider the large trade deficit in goods and services we saw in January due to U.S. firms’ strategy to preempt tariffs, which pushed imports to very high levels and to a historic record. This has pushed down our GDP forecast from 2.4% to 2.0%. We will continue to adjust our forecast as we get more information on tariffs and their potential effects on inflation.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those of Raymond James and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Past performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

Employment cost Index: The Employment Cost Index (ECI) measures the change in the hourly labor cost to employers over time. The ECI uses a fixed “basket” of labor to produce a pure cost change, free from the effects of workers moving between occupations and industries and includes both the cost of wages and salaries and the cost of benefits.

US Dollar Index: The US Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the

U.S. dollar gains "strength" when compared to other currencies.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households.

Producer Price Index: A producer price index(PPI) is a price index that measures the average changes in prices received by domestic producers for their output.

Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.

The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

Conference Board Coincident Economic Index: The Composite Index of Coincident Indicators is an index published by the Conference Board that provides a broad-based measurement of current economic conditions, helping economists, investors, and public policymakers to determine which phase of the business cycle the economy is currently experiencing.

Conference Board Lagging Economic Index: The Composite Index of Lagging Indicators is an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.

New Export Index: The PMI New export orders index allows us to track international demand for a country's goods and services on a timely, monthly, basis.

Gold is subject to the special risks associated with investing in precious metals, including but not limited to: price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in countries that have the potential for instability; and the market is unregulated.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

Source: FactSet, data as of 12/6/2024