The surge in oil prices will alter the trajectory of inflation this year; while lackluster investment and trade policies may weigh on the growth outlook.

There’s a shock to headline inflation working its way around the world, reflecting the sharp rise in oil prices. The United States will feel this more than anywhere else because of the level and structure of gasoline taxes. The surge in oil prices changes the inflation trajectory for this year. Core inflation looks slightly different across the major economies. In the United States, inflation is approaching the Federal Reserve’s 2% target, and the Fed seems quite comfortable with the outlook for 2018.

Rising prices and lackluster investment

While the underlying story hasn’t changed, we are less optimistic about the growth pace in 2018. The economy grew at an annual rate of 2.3% in the first quarter of 2018 due to lower private consumption and government spending. Growth is below the 2.9% annualized rate in the fourth quarter of 2017. Cyclically, the United States could enjoy a late-cycle boost in growth, driven by fiscal measures, including the 2017 tax changes and the spending deal Congress forged in 2018. While a pickup in growth is possible, it may be somewhat less pronounced because of higher oil prices, lackluster corporate investment, and trade policies.

The increase in oil prices could affect consumption and the economy. Oil prices rose to three-year highs in April, and gasoline prices have followed suit. As a result, we expect headline and core inflation to rise. American households will have to adapt to higher gasoline prices; either they will reduce spending on other items, or they will dip into their savings. The backdrop of rising fuel prices also threatens to offset the benefits of lower taxes on the bottom half of the income distribution. Since consumption growth relies more on spending by people in the upper half of the income distribution than the lower, this effect isn’t large, but it is still present.

Early signs of corporate investment are not encouraging. Lower corporate taxes weren’t going to significantly change GDP via the investment channel. While investment has edged up, non-residential investment accounts for only 12% of GDP. The tax changes may boost it to about 7% year-on-year from about 5%. This will support growth, but arithmetically it’s not a big number. We are lowering our expectations for a different and stronger GDP trajectory. The corporate investment channel is simply not enough to do a whole lot for GDP.

Trade policy risks loom

There are signs business confidence was affected by trade disruptions being imposed and contemplated by the Trump administration. The approach taken with the United States–Korea Free Trade Agreement (KORUS) and North American Free Trade Agreement (NAFTA) is not going to apply with China. Even if the eventual outcome ends up to be a modest change, which is possible, the rhetoric and threats will heat up. The Chinese also seem to be digging in on their side; they have stopped buying U.S. soybeans. So, overall demand has changed as China places orders with Brazil and other growers. Business surveys indicate concerns about the price effect of steel and aluminum restrictions, and more general concerns about the impact a trade conflict with China would have on global supply chains. These worries aren’t likely to dissipate in the short term.

The Fed’s outlook

How does the Fed decipher the outlook? The Fed’s confidence in the economy is high. But, we expect only two more rate hikes this year. The recent Fed minutes removed a statement about the strengthening economic outlook and added in “symmetric” when referencing inflation. This indicates the Fed does not expect inflation to accelerate materially even if it rises above the 2% target in the near term. Therefore, four hikes in 2018 is a low probability.

However, the Fed is set to keep on hiking beyond 2019 due to a steadily growing economy and a tightening labor market. The risk is that they’ll get the pace wrong. This risk is real given the additional tightening from the balance sheet contraction, and the stresses created by the Fed raising rates, while pretty much everyone else sits on their hands.

Next: The ECB’s policy dilemma

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Our outlook contains some small but noteworthy shifts. Rising oil prices are expected to lift slightly the trajectory of inflation in the United States because of the pass-through to consumer prices.