Heavy Is The Crown
All credibility, all good conscience, all evidence of truth come only from the senses. ― Friedrich Nietzsche
Today, many economists and policymakers outside the United States are concerned about a potential second Trump term, primarily due to his proposal to reinstate tariffs. In this respect, his stance appears similar to that of 19th-century mercantilists, who promoted exports while shielding domestic industries through high tariffs. At the time, countries encouraged export industries but imposed protectionist measures to support local production. In contrast, as early as the 18th century, Adam Smith argued for free trade, asserting that nations should focus on producing goods where they had an absolute advantage and then trade for mutual benefit.
However, David Ricardo laid the deeper theoretical foundation for trade with his concept of comparative advantage. A former businessman with a strong interest in economic theory, Ricardo wrote Principles of Political Economy and Taxation in 1817, where he advanced a more sophisticated view than Smith's on how trade benefits nations. His theory of comparative advantage suggests that countries should specialize in producing goods where they face a lower opportunity cost than other nations, underscoring the importance of relative over absolute efficiency. This insight supported the argument that free trade promotes economic growth by allowing countries to leverage their unique strengths and foster competition and innovation. Ricardo’s work was an essential advocacy for free trade and remains a core tenet of economic theory today.
Ricardo’s ideas, however, have not gone without criticism. Later economists, especially those aligned with protectionism, argue that free trade may lead to job losses in specific industries and could worsen income inequality within countries. Ricardo’s model, which assumes that production factors are mobile domestically but immobile internationally, may also seem limited when applied to a globalized world. Nonetheless, Ricardo's theory remains highly influential in economic policy and academic discussions, underlining the enduring relevance of his insights in shaping globalization and trade relations.
Interestingly, Ricardo’s theory of comparative advantage can also be viewed as advocating for the division of labor at an individual level, as it applies to people as much as it does to nations. This perspective raises questions about the argument for restricting imports to “protect” jobs, as it implies paying more for goods locally—an idea few would endorse on an individual level. While beneficial to certain domestic producers, tariffs inevitably come at the expense of consumers, who pay more and thus have less to spend on other goods and services, sometimes even at the cost of quality.
While some view Trump’s call for tariffs as regressive, this perspective alone might miss part of the picture. Modern trade agreements often fall short of genuinely free trade, laden as they are with conditions and restrictions. Trump argues that while the US maintains relatively open import policies, other countries frequently impose trade barriers. Seen this way, his critique of “unfair” trade is understandable, as it addresses an imbalance in trade access. In his first term, Trump proposed that both the US and EU:
"The European Union is coming to Washington tomorrow to negotiate a deal on Trade," he wrote later in another tweet. "I have an idea for them. Both, the US and the EU drop all Tariffs, Barriers and Subsidies! That would finally be called Free Market and Fair Trade! Hope they do it, we are ready – but they won't!"
From this perspective, it becomes clearer what Trump means by “unfair.” European and Chinese politicians advocate for free trade primarily when it benefits their own exports to the US, yet they often impose barriers when importing US goods. Instead of simply criticizing Trump, European leaders might consider proposing the removal of all trade barriers with the US and then waiting for his response.
Currently, markets are anticipating the outcome of next week’s US election, and momentum appears to have shifted in Trump’s favor over Harris. Still, with inflation concerns weighing on Americans, economists have recently voiced worries that a Trump victory could lead to higher inflation than a Harris win. According to a Wall Street Journal survey conducted October 4-8, 68% of economists polled believe that Trump’s economic policies would result in higher inflation than Harris’s approach.
This belief is based mainly on Trump’s proposed 60% tariff on Chinese products, which would likely drive up the prices of imported goods. However, this effect would likely be temporary, all other things being equal. As consumers continue purchasing imported goods, overall consumption of other goods and services would shrink, thus pushing down prices in those areas. For this reason, the warnings of prolonged inflation due to tariffs may be overblown. Interestingly, the Federal Reserve holds a similar view. In 2018, Fed economists evaluated the potential impact of tariffs, concluding that any rise in consumer prices would be temporary.
The more accommodative policy response considered here attenuates the output decline considerably relative to the previous scenario without much effect on inflation. Accordingly, the see-through policy would seem an appropriate response to a tariff hike.
That aligns with the Austrian economics perspective, which argues that tariffs introduce a short-term disequilibrium that pushes prices higher before they adjust to a new equilibrium. Sustainable inflation results from an expanding money supply outpacing output growth.
However, from a long-term investment standpoint, the US fiscal outlook may more strongly influence inflation pressures. Recent interest rate increases have driven US interest expenses to surpass defense spending, though this remains lower than during the 1980s or 1990s as a share of GDP.
While I wouldn’t go so far as to claim that concerns are entirely unwarranted, I would argue that the situation is not as urgent as many commentators suggest. The Committee for a Responsible Federal Budget estimates that the fiscal impact of a Trump presidency could be worse than under a potential Harris administration; however, they acknowledge that their estimates come with significant uncertainty. In my view, history suggests that the fiscal trajectory will likely worsen regardless of who ultimately wins.
The Federal Reserve could ease some of this pressure by further reducing the federal funds rate. However, cutting rates to alleviate the US fiscal position would be risky for the Fed, as it could compromise its credibility. Jerome Powell essentially justified the latest 50-basis-point rate cut by indicating that the Fed is now focusing more on labor market stability. That said, Powell may soon find himself in a more challenging situation rather than a simpler one. Heavy Is The Crown.
Currently, the labor market remains robust and far from showing significant signs of decline, although recent data indicates a modest slowdown. Some analysts point to the recent sharp drop in job openings as a sign of a potential cooling in labor demand. The latest job openings number came in below expectations, suggesting that the labor market may be softening.
Yet, if we look at job openings relative to total employment, we see that the labor market has tightened significantly since 2015 compared to trends seen since 2001. Since 2020, job openings have consistently outpaced job growth, signaling rapid tightening in the labor market. Although recent declines in job openings suggest some easing, the market remains extremely tight, having just returned to its average since 2015—a period associated with a strong labor market.
Judging by indicators such as Nonfarm Payrolls and the unemployment rate—still near multi-decade lows—the 50 basis-point rate cut may not have been necessary. While one could argue that CPI has been falling and is slowly approaching the Fed’s two percent target, there remains a broad perception that rates are high enough to restrain economic activity. It seems that the Fed may be reluctant to maintain higher rates due to concerns about the economic pressure they impose.
Turning to other economic indicators, we recently received the October S&P Global Flash PMI and sentiment indices from the University of Michigan and the Conference Board. If this data signals economic weakness, it might imply that labor market conditions could worsen down the line. In theory, declining sentiment among producers and consumers can lead to reduced economic activity, lower consumption, and, thus, a decreased demand for labor and other resources.
Starting with October’s Flash Purchase Manager Indices from S&P Global, the composite index reached 54.3—a two-month high—while the services index rose to 55.3, and the manufacturing index hit a three-month high at 47.8. This activity was primarily driven by expansion in the services sector, while the manufacturing sector contracted more modestly than in previous months. Future sentiment was promising, though recent volatility suggests some uncertainty due to the upcoming elections:
Looking further ahead, having slumped to a 23-month low in September, optimism about output in the coming year rebounded sharply in October, hitting a 29-month high.
On employment, the report noted a modest decline, consistent with the analysis above, while price pressures eased in October, though input costs remain above historical averages. The manufacturing sector's main drag was new orders, although the rate of decline lessened. Chris Williamson, Chief Business Economist at S&P Global, highlighted strong demand and higher sales driven by competitive pricing.
Furthermore, S&P Global's annualized GDP estimate for Q3 is around 3%, with inflation easing. This supports my previous view that nominal growth will remain strong, driven by high real growth. In short, the report suggests that economic activity remains robust and inflation is easing. Refinancing conditions should ease if the Fed continues to cut interest rates as projected, offering businesses more flexibility.
Since the report doesn’t signal an urgent need for a rate cut in the real economy, it’s worth examining consumer sentiment indices from the University of Michigan and the Conference Board to assess whether a fall in consumer demand is likely. Neither report, however, shows alarming signs from the consumer side.
The University of Michigan reported another rise in consumer sentiment, though it noted some election-related uncertainty. Year-ahead inflation expectations remained steady, while long-term expectations dipped slightly, suggesting continued consumer optimism.
The Conference Board’s report also saw a significant increase in October, with expectations rising from 99.2 to 108.7. The short-term outlook for income, business, and labor market conditions climbed well above the recessionary threshold 80. Dana M. Peterson, Chief Economist at The Conference Board, commented:
Consumer confidence recorded the strongest monthly gain since March 2021 but still did not break free of the narrow range that has prevailed over the past two years...In October’s reading, all five components of the Index improved...Compared to last month, consumers were substantially more optimistic about future business conditions and remained positive about future income. Also, for the first time since July 2023, they showed some cautious optimism about future job availability.
While the Michigan Expectations Index hovers around its historical average, the Consumer Confidence Expectations Index remains well above its historical average.
In summary, the labor market, economic activity, and consumer expectations apparently do not suggest that the economy needs more interest rate cuts. The labor market is stabilizing, and business activity and consumer expectations show improvement. Further rate cuts would likely only enhance this momentum by easing financial conditions.
Consumer spending has remained resilient despite high uncertainty around the upcoming election. Gold and stocks have risen sharply this year, with gold outperforming equities, while bonds have become very volatile. Household balance sheets have also recovered to pre-GFC levels. This raises a fundamental question: will the Fed truly ease financial conditions in this economic environment?
The Fed’s claim of a possible labor market weakness seems unlikely to materialize in the short term. The main factors justifying continued rate cuts are lower inflation and the government’s rising interest expense. The government would benefit from reduced interest costs, while financial markets would welcome lower rates to boost prices as real rates continue to climb, potentially challenging future asset price growth.
Former Fed Governor Kevin Warsh highlighted these contradictions in a recent CNBC interview, noting his “puzzlement” at the recent rate cut given the Fed’s earlier stance. Warsh criticized the Fed’s evolving approach to inflation targeting, which moved from “average inflation targeting” to focusing on core PCE and then to “core services ex. housing,” adding layers of inconsistency.
Warsh argued that the Fed lacks a coherent inflation theory and has failed to effectively address its role in rising prices. When asked whether it’s understandable that different data would take precedence at various times, Warsh responded with what felt like a brutally honest assessment:
They say that they're data-dependent... but the data has gotten better. The economy has strengthened, and the stock market is in better shape. If that's all true, maybe they're not data-dependent.
Warsh argued that the Fed's lack of data dependency makes accusing the institution of playing politics easier. When asked whether the Fed should push back against Congress regarding excessive spending, he pointed out that the Fed helped create that political environment by maintaining near-zero interest rates after the GFC and by purchasing US government bonds permanently. This effectively signaled to politicians that they could spend freely without consequence. The Fed’s monetary policy encouraged such behavior and incentivized banks to exploit the arbitrage of earning interest on their reserves instead of lending to the real economy.
Warsh also noted that the Fed has shifted away from a straightforward monetary policy approach and entered an intervention spiral. During the Greenspan era, the focus was primarily on the Fed Funds Rate; now, however, the Fed is juggling multiple rates, including the interest on reserves.
Additionally, he pointed out that the Fed has turned assets beyond Treasury bonds into risk-free options that compete with them. This shift indicates the Fed’s decision to assume a permanent role in financial markets, partly due to its unanchored framework and the pursuit of often conflicting objectives. For example, while the Fed is currently engaging in quantitative tightening (QT), it also plans to cut interest rates, effectively tightening and easing financial conditions simultaneously.
Warsh suggested that the FOMC members should speak less and focus more on their role in financial markets, urging the Fed to prioritize the real economy over financial market fluctuations. I completely agree with him, although I suspect that many participants in financial markets might not. Warsh is also correct in asserting that the Fed has damaged its credibility more through its repeated missteps than through attempts by politicians to discredit it. One of his observations succinctly captures this sentiment:
It’s hard to judge the economy’s strength because liquidity is everywhere… Recently, the Fed cut rates by 50bps; yet when inflation was 7-9% and they wanted to quash it, they waited nine months to raise rates by only a quarter-point. There’s a puzzling symmetry. They lower rates believing conditions are restrictive, yet I’m looking and can’t find that restrictiveness.
Essentially, Warsh argues that if the Fed continues to lower interest rates, it may temporarily boost stock prices. However, it also risks driving up long-term rates, which could tighten refinancing conditions for longer-term investments and potentially halt the stock market rally. For now, it seems that bonds may find a near-term bottom and rise before possibly declining again. If that thesis proves correct, the dollar has also recently peaked and may drop slightly before potentially rising again.
Ultimately, the Fed's actions will be critical in shaping these dynamics. At some point, the complexities it has introduced may become unmanageable, and its claim to preserve the labor market from weakening could merely be a façade to support the government's deficit situation. However, Jay Powell and the Fed have maneuvered themselves into a difficult position through endless market interventions and the belief that increased central monetary planning comes without consequences. For now, Heavy Is The Crown.
This is what you asked for, heavy is the crown
Fire in the sunrise, ashes rainin' down
Try to hold it in, but it keeps bleedin' out
This is what you asked for, heavy is the, heavy is the crownLinkin Park – Heavy Is The Crown
Have a great weekend!
Fabian Wintersberger
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All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change over time in response to evolving facts. It is strongly recommended to seek independent advice and conduct your own research before making investment decisions.