As we roll through the 1st quarter, we continue to see factors that support positive momentum in the economy. This includes a $200 billion stimulus from the tax reform bill, a $300 billion two year spending bill passed by Congress and now indications that Congress is going to include infrastructure spending as part of the spending bill. This has resulted in consumer and business confidence remaining at or near record levels.
By now, the consumer has seen the actual improvement to their paycheck due to the reduced withholdings from the tax reform bill. The National Federation of Independent Businesses characterized business in February as “roaring” for their small business members. Clearly, enthusiasm, optimism and confidence are in play. Amid this enthusiasm are two underlying issues that may ultimately decide how much the economy benefits from tax cuts and infrastructure spending: rising interest rates and the tariffs being initiated by the Trump administration.
Rising Interest Rates
With all of the good economic news that has been rolling across the headlines, what has been lost is the fact that rising interest rates will be consuming more of consumers take home pay, businesses profits and the government’s tax revenues. To give some perspective, here is what every 1% increase in interest rates does to annual interest expense for new borrowing or for loans that are variable rate with resets upcoming:
Consumer: for every $100,000 = $1,000 per year
Business: for every $1 million = $10,000 per year
For the US government: for every $1 trillion = $10 billion per year
What has been lost in many headlines is the fact that consumer debt is at record levels. Currently, consumers are borrowing to fund their spending. Apparently, with the high consumer confidence levels, consumers believe that their paychecks will begin rising and are willing to borrow in advance of the actual pay increase. With the passage of the tax reform bill and the new spending bill, the deficit for the US is going to widen. This is forcing the government to borrow more money while interest rates are rising.
Earlier in the year, the Trump administration imposed tariffs on washing machines and solar panels. Last week the Trump administration announced additional tariffs on steel and aluminum. All else being equal, tariffs raise the cost for imports of the products targeted by the tariffs. Historically, that has led to higher prices for US consumers and businesses that buy those products. Washing machines and solar panels may not have had much impact on our economy since those are isolated products. Steel and aluminum are far bigger factors since they are used throughout multiple industries and consumer products. The auto industry and the National Association of Home Builders have already come out and said that this will cause auto prices and the cost of homes to rise.
The risk that needs to be monitored is the potential double whammy to “large ticket” consumer items. For example, if prices of houses and automobiles rise in response to the tariffs and the cost of financing these items rises due to rising interest rates, then we could see sales of these and other items fall as less consumers can afford to buy the products.
Just as importantly, tariffs could cause the countries affected by these tariffs to retaliate and impose tariffs on US products. All else being equal, this would hurt export sales as the cost of our goods would become more expensive.
The key that we need to monitor is wage growth. If wage growth starts to accelerate, then consumers may be able to afford the higher prices and higher financing costs. Without wage increases, consumers may be forced to cut back on discretionary purchases, including homes and automobiles, because the tax cuts were offset by the higher product costs and the higher borrowing costs. All eyes will be on Friday’s employment report to see if the 2.9% annualized increase in average hourly earnings in January continues or if it was a one-time, weather related anomaly.
For those history buffs, remember the mistake made during the midst of the Great Depression: the Federal Reserve raised interest rates and Congress passed the Smoot-Hawley Act which imposed stiff tariffs on imported goods. I am making no case that this is what we are experiencing now. I am simply saying that the time to manage risk the closest is when optimism is at its highest. For now the impact from rising interest rates and tariffs is a risk to be monitored. The actual impact remains to be seen but bears close monitoring.
Steve Scranton is the Chief Investment Officer and Economist for Washington Trust Bank and is a CFA charter holder with over 30 years of investment experience with equities, tax-exempt and taxable fixed income securities. Steve actively participates on committees within the bank to help design strategies and policies related to client and bank owned investments. Steve also serves as the economist for the Bank and has been a featured speaker for both client and professional organization events throughout the Northwest.