The US economy is slowing because of the Fed, not because of the dispute with China

In recent days, world capital markets have convulsed. It is widely said that this is the result of the aggressive trade negotiation that US President Donald Trump is having with China.

Today, the first thing I want to look at is the effects of Trump's tariff proposals, relative to the size of US GDP. I then want to look at the position of US financial markets, relative to their underlying fundamentals.

Perhaps the most unbelievable thing that is actually true about Donald Trump is he has a university degree in economics, from one of the very best economic schools in the US. When he graduated from the Wharton School of the University of Pennsylvania, it was one of the top five economic schools in the country. It remains in that elite group. Trump really does know what he is doing with his negotiations with China.

In the first two years of his administration, the most significant thing that the Trump Administration did was pass tax reform. One of the most dramatic results of that tax reform was to reduce US corporate taxes to a rate of 22%. When this tax cut was first proposed, it was to be funded by the introduction of a "Border Adjustment Tax". This meant that the cost of imports into the US would no longer be tax deductible.

At that time, the estimated final corporate tax rate was 20%. Imports into the US economy are 15% of GDP. Had this Border Adjustment Tax been introduced, then the result would have been (assuming that the cost had been passed through to US consumers) an increase in US prices of 3.0%. This increase in prices and increase in revenue was intended to fund the tax cuts and reduce the budget deficit. Importers lobbied heavily against the Border Adjustment Tax and the net result was that the corporate tax rate fell to 22% instead of 20%, and the cost of funding this was provided by an increase in the US budget deficit.

It is perfectly plausible that as a result of these events, Trump now believes that he has this 3% number still to play with. As long as the effect of his increases in tariffs are no larger than 3% of GDP, then the result will be merely to reduce the US budget deficit to levels originally envisaged, when the corporate tax legislation was initially introduced.

This concept of 3% of GDP is important when we look at the strategy that Trump is employing on China.

So far, Trump has levied a 25% tariff on $US250 billion of Chinese imports. The revenue that results from this increase in tariffs is $US62.5 billion. US GDP for the year to the second quarter of 2019, is $US21,340 billion ($US21.3 trillion for short). Compared to this enormous GDP, the increases in Chinese tariffs already applied is only 0.2928% of GDP. This increase might flow through to prices, but academic research suggests that this increase in prices is more likely to be absorbed by importers. The point is, the impact of the tariff increases on Chinese imports have on the US economy is somewhere between negligible and tiny.

Trump has now threatened to add an additional 10% tariff on a further $US300 billion of Chinese imports. If he would do this, this would add a total cost of $US30 billion. The total increases of tariffs on Chinese imports would then amount to $US92.5 billion. Compared to a US economy of $21,340 billion, this would have a total effect on the US economy of 0.433%. This is still negligible.

Importantly, the effect on US imports is still only a small fraction of the 3% that was previously considered as the result of the introduction of the Border Adjustment Tax. This means that Trump is playing very much within a safe range even if his threats on Chinese tariffs are fully implemented. Trump's activity in this aggressive trade negotiation with China is in no way threatening to the US economy.

What is actually happening in the market?

What is actually happening in the market is that the US economy has slowed from a growth rate of around 3% per annum, to a growth rate of around 2% per annum. This slowdown has nothing to do with trade policy. It is the direct result of the gradually tightening of monetary policy over the past two years by the US Federal Reserve. Their objective was to slow the US economy to around 1.8% growth rate, so that they can continue a modest growth rate in employment, and still avoid a US recession.