Protectionism Would Slow Pace of US Fed Rate Hikes, Say Economists

May 3, 2017 Updated: May 3, 2017

It’s likely still early days as far as the U.S. Federal Reserve is concerned about protectionism being a threat to economic growth.

While uncertainty continues to surround the Trump administration’s fiscal policy, what might be getting clearer is its trade policy. On April 24, the Trump administration hit Canada with a 20 percent tariff on softwood lumber imports. Gregory Daco, Head of U.S. Economics at Oxford Economics in New York, said in a phone interview that, for now, the administration’s approach is “trying to level the playing field.”

In a research note, RBC called the tariffs on softwood lumber a “shot across the bow.” And while the investment bank doesn’t expect a significant impact from this particular action on the Canadian economy, it said, “The shift in tone from our largest trading partner could be a sign of how aggressive the new administration will be in any NAFTA renegotiation.”

Canada shipped $9 billion of softwood lumber products in 2016 to the U.S., which represents about 0.4 percent of Canadian gross domestic product (GDP), according to the research note from RBC.

If a country adopts more protectionist policies, that tends to generate a reaction from other countries.
— Gregory Daco, Oxford Economics

If there were to be severe protectionist policies put in place, it would reduce economic growth and the Fed would slow down its pace of raising interest rates, Daco said.

Protectionist policies like tariffs or quotas raise the price of imports and curb export growth, which is negative for GDP.

Also, the country imposing protectionist measures typically sees its currency appreciate, while the country on the receiving end sees the value of its currency fall. The Canadian dollar fell sharply below US$0.74 on April 24 to its lowest level since January 2015.

A stronger greenback represents an unwanted headwind for the U.S. economy as it dampens already-below-target inflation.

“If we see an increase in outright protectionist moves or the threat of protectionism, I think the Fed would clearly take that into its decision-making process,” said BMO senior economist Sal Guatieri in a phone interview. He added that protectionism represents a downside risk to the Fed’s economic and inflation outlook, which would warrant a more gradual approach to raising rates.

Guatieri pointed out that the Fed also sees an upside risk from the prospects of greater fiscal stimulus, but that for now, the two risks offset each other.

Economists and central bankers agree freer trade is better for economic growth. “If a country adopts more protectionist policies, that tends to generate a reaction from other countries,” Daco said. The reaction is very similar, Daco added.

He does not necessarily believe the Trump administration is going to pursue extremely protectionist policies, but just wants a better deal out of the NAFTA negotiations.

Still on Course

As expected, the Fed held the target range for fed funds at 0.75 to 1.00 percent on May 3. The Fed sees the first quarter economic slowdown as “likely to be transitory” and appeared to strengthen its case for the two more rate hikes planned for 2017, according to its March projections.

The U.S. economy grew a meagre 0.7 percent over the year ending in March; inflation fell 0.2 percent for the month of March and is just below the Fed’s 2.0 percent target at 1.8 percent for the year ending in March.

The Fed can gain confidence that inflation is picking up and labour market slack is basically non-existent given wage inflation is moving higher. The employment cost index (ECI) rose 2.4 percent in the first quarter.

Markets were pricing in roughly a 70 percent chance of a June hike prior to the release of the interest rate decision. Those expectations moved to about 75 percent, according to CNBC after the Fed statement was released. For now, the economic slowdown and initial protectionist moves are not swaying the Fed from its course. 

Follow Rahul on Twitter @RV_ETBiz

Follow Rahul on Twitter: @RV_ETBiz