The Fed looks overly optimistic on the US outlook
IMF analysis suggests that the Fed is too optimistic on the likely impact of initial Trump tariffs.
Last week, the Federal Reserve updated its economic outlook, with the FOMC marking down the median forecasts for economic growth over the next couple of years, while making only a relatively small upward revision to inflation and leaving the forecast unemployment rate unchanged.
The FOMC does not disclose the assumptions underpinning its forecasts, but based on past comments the updated outlook likely only incorporates the expected impact of announced tariffs.
In that respect, Fed Chair Powell said the revised numbers assume that the impact of tariffs on inflation is transitory, although he acknowledged some inertia in revising the forecasts and stressed the uncertainty around the outlook, where nearly every FOMC member thinks that the risks are that growth ends up weaker and inflation and unemployment both end up higher.
In an attempt to quantify these risks, the table below compares the revisions made to the Fed’s outlook with the estimated impact of announced tariffs based on IMF work.
The IMF did a huge cross-country study of tariffs some time back, undertaking a panel data analysis of about 150 countries for the early 1960s onwards.
Not surprisingly, the IMF’s concluded that higher tariffs cause significant economic damage, reducing activity, while increasing unemployment, inequality, inflation, and the real exchange rate.
Interestingly, the IMF found little net effect on the trade balance, where reducing trade deficits with China, Canada, Mexico, and Europe is a key goal of the Trump tariffs. This likely reflects the loss of competitiveness from the higher real exchange rate.
The main IMF charts are shown in the panels below, which provide the estimated impact of a one standard deviation increase in the tariff rate (or 3.6pp) on key economic indicators over time.
Scaling up these results to capture recently-announced tariffs lifting the effective tariff rate from about 2½% last year to around 12%, the IMF annual estimates – which admittedly only approximate the revisions to the Fed’s end-year forecasts – show a similar hit to economic activity over the next couple of years, but with the FOMC appearing overly optimistic in making no revision to its forecast unemployment rate, while also understating a likely large boost to inflation.
Importantly, this comparison only captures the initial stage of the tariffs, where the likely economic impact will be substantially larger if the administration adopts broad reciprocal tariffs next week and follows through on large threatened tariffs on key goods, such as automobiles, and the European Union.
They also do not take into account the hit to activity from extreme policy uncertainty, where uncertainty should lead to consumers and businesses delaying spending, investment and hiring.
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Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy, contributing to the investment decisions of the firm. Kieran has long experience as a macroeconomist in both the private and public sectors. He has worked most recently as Chief Markets Economist for National Australia Bank and was previously Chief Economist, Australia and New Zealand, for Barclays Bank and ABN Amro Bank/RBS. Kieran also worked as Principal Adviser on the macroeconomy and budget policy in the Commonwealth Treasury and Director of Forecasting.
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Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...
Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...
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