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Hello and welcome to our latest video #MacroMemo. There's always a lot to talk about and this week is no different. And so the plan for the next few minutes is to talk about rate cutting in the context of the U.S. Fed (Federal Reserve) and the Bank of Canada. We'll talk a bit about the risk of a U.S. government shutdown in the near future.

We'll talk as well about tariffs. That's been a constant in recent months, specifically in the context of inflation and actually why we shouldn't expect 19% inflation, even though the average U.S. tariff is 19%. So we'll talk just through the logic behind that.

There's been some interesting work done recently on the connection between artificial intelligence and job losses, in particular in younger workers. We’ll speak about that.

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And finally, just a quick peek at the U.S. risk premium in the bond market and how it's maybe not quite as big as you might have imagined.

Let's start at the top. And so let's talk central banks. It was actually a very busy period of time recently for central banks. That included such central banks as the Bank of England, the European Central Bank, and the Bank of Japan making decisions. But their decisions were all the same: to leave their policy rates unchanged. So let's set them aside for the moment.

The action came in North America, where we had the Fed (U.S. Federal Reserve) cutting by 25 basis points on September 17th, and the Bank of Canada actually doing exactly the same thing, cutting by 25 basis points also on September 17th.

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For the Fed, that was the first rate cut of 2025, the first since 2024 in December. It was motivated, at least in the Fed's words, by risk management. They could see that the risks to the labor market, in particular the downside risks are mounting. And that does appear to be the case as hiring slows and the unemployment rate edges slightly higher.

I think the other motivation certainly would be the reality that the fed funds rate is pretty high. It was sitting at 4.375% going into this decision. It's still slightly north of 4% coming out. And that's been fairly substantially out of step with other central banks.

Similarly, it's a certain distance above what you might deem to be a neutral rate in the U.S.

And so they've decided to cut rates, with a fair amount of dissent within the decision. There was a 50 basis point preference from new Fed Governor Myron, a recent Trump political appointee. And so he seems to be at the dovish extreme of the spectrum.

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Looking forward, there are two camps in the Fed.

There is one camp that thinks that one cut already delivered is enough for this year. There is another sizable camp that thinks there could be two more cuts before the end of the year. So not a trivial difference. It looks for the moment as though the votes do tilt more toward the dovish set of voters. And so I think it's more likely than not that we do perhaps get two more rate cuts.

But let the record show it is unlikely to be a unanimous decision. There is a degree of data dependency here.

We're of the view, in particular when you look at what the market has priced all the way out into 2026, that there might be a little bit less rate cutting than the market thinks. Nevertheless, there's probably a fair amount of easing that is still possible over the next year or so.

For Canada, I just want to acknowledge a Bank of Canada rate cut as well, the first cut since the spring.

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So not the first of the year. It was motivated in Canada's case, I think, a bit more clearly. There is significant economic slack. The unemployment rate is a fair amount too high in Canada. Inflation has been not too poorly behaved. And as Canada has pulled back its retaliatory tariffs, the risk of a tariff-based inflation flare-up in Canada has gone down fairly significantly.

The market prices another rate cut, more likely than not, before the end of the year. That sounds reasonable, though there's data dependency. That will depend on how the numbers play out.

Market does not price a lot more cutting in 2026. We think there could be a bit more. So we would say there might be a bit more easing out of Canada than the market currently imagines.

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Let's shift topics. Let's talk about government shutdown risk. This is a U.S. topic. The American fiscal year ends on September 30th at the federal level, and there has not been a new budget that has been agreed upon. And so without that, there would be a government shutdown as of October 1st. Polymarket, one of the betting markets out there is, at least as I'm recording these words, assigning a 71% chance that the U.S. government does shut down.

There was an effort on September 19th to pass a stopgap spending bill that would have really punted the problem down the road into November. That failed. You need a supermajority in the Senate to pass, and the Democrats didn't support it. Indeed, a few Republicans didn't either. And so they were well short of what they needed.

The Democrats want more health care spending, really a resumption of health care spending . . . undoing the Medicaid cuts from the summer, undoing some expiries of health insurance subsidies that happen at the end of this year as well. It seems unlikely they'll get all of that.

Republicans may be more tolerant of a shutdown as well than normal, in the sense that, of course, there is this appetite to shrink the size of the U.S. government.

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And a shutdown does do that, if in a radical and unsustainable way. But it could perhaps reveal less critical government departments or things like that.

And so a shutdown does seem more likely than not. It’s not a certainty. You may be watching this in the future and know that it did or didn't happen. And so I apologize if that's the case. But from our vantage point right now, it does look a bit more likely than not.

The longest shutdown in history was actually in the first Trump term. It was about a month. And so just to give you a sense of length, shutdowns are normally less than that, but perhaps up to something like that. In that episode, the U.S. GDP (gross domestic product) fell by about 0.2% in terms of output in a quarter. Unemployment rose by about 0.2 percentage points.

So those are the stakes of what we're talking about. It is, though, inherently temporary. When you get the resolution and a budget passed, you do that and see of course the rebound happens later. I do want to emphasize essential services are still provided during a shutdown. It's just non-essential services that are cut out.

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It’s absolutely fair to say the timing is not ideal though, in the sense that the American economy is already decelerating a little bit due to tariff damage. So not the strongest of starting points or footings. Of course, we've just been through a period of pretty extraordinary policy uncertainty. And so this will again add, at least temporarily, to policy uncertainty, maybe discouraging CapEx and that sort of thing.

So not ideal, but nevertheless something we'll have to grapple with, I think, this fall.

Let's shift over to tariffs. So tariffs are normally topic number one, two and three whenever we're talking about the economy these days. But there has been frankly less action on the tariff file recently which is maybe a good thing. We have some clarity as to what the tariffs are likely to be going forward, though I should mention still considerable uncertainty around things like the USMCA (United States-Mexica-Canada Agreement) deal and some sector tariffs.

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I don't doubt there may be some country level deal struck with countries that failed to strike them back in August at some point, so we'll see further action in the future. But it's been a quieter period recently. I mentioned all that just to say, let's talk a bit about the inflation side and tariffs. We are continuing to see, we think, that the effects of tariffs on the inflation numbers is not overwhelming. If anything, it’s maybe a bit lighter than expected.

But when you dig into the theoretically most affected sectors, areas like appliances and apparel and furnishings and sporting goods, the prices of those products, we do see some incremental increase. It's been buffered by lower oil prices. It's been buffered by lower shelter costs. But on the aggregate, we do see some additional inflation showing up.

I had a client question recently, I think it's a good one, which is if the average U.S. tariff is 19%, how come the price of everything in the U.S. isn't going up by 19%? And so let's just do a quick little thought exercise here. The answer is that 19% is diminished by a number of things. And I won't speak to every number along the way.

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But I'll just give you a sense for this, which is first of all, that 19% is applied to the import price. There is then a markup by the wholesaler, a markup by the retailer. So the 19% tariff actually ends up being more like a 10% number by the time you hit the actual price paid by consumers. And so that that tempers it to some extent.

I can say as well that there is usually some sharing of the burden by other parties. We can see foreign manufacturers have eaten a bit of the tariff. We can see that some American manufacturers have eaten a bit of their fraction of the tariff. And so let's say maybe two thirds of the tariff actually accrues to the consumer.

So you're now talking about maybe a 6 or 7% increase in the price of imported goods. Of course, when you look at consumer products, not all goods are imported. In fact, only about a third are. So you divide by three and now you're sitting at sort of a 2.5% kind of inflation rate, just for goods in general.

Of course, not all things that consumers buy are goods. In fact, only about a third of what they buy are goods. And so you divide by three again, because services aren't directly tariffed and you end up with maybe at most a one percentage point increase in prices. And that's actually about what we budget for. So that's how you get from a 19% tariff rate to a 1% increase in consumer prices or thereabouts.

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Okay. Let's talk AI, a hot topic. We are optimists in the sense of thinking it can drive productivity and innovation significantly over the next few decades. There is a risk, though, to employment, the extent to which AI replaces or supplants workers.

So far that's been mostly a matter of conjecture. But there is a new Stanford research paper that does seem to find that there has been some damage done.

It's very specific, though. And so it's not most workers, it's early career workers, aged 22 to 25, in the most AI-exposed occupations. And so they would define that as including things like computer programing, customer service representatives, that sort of thing. So in that specific Venn diagram intersection of young workers and those particular sectors, I think they do see about a 13% decline in employment versus what you would normally expect.

And they say it started to become visible in late 2022, which is when ChatGPT burst onto the scene. So it does square together fairly well. They don't see damage to older workers. One thesis there is just that experiential knowledge may be harder to supplant. The book learning that young people have might be easier for AI to work with and to replace.

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Another theory as to why younger workers are doing worse right now is not linked to AI. The fact that there are economic concerns means that we're not seeing a lot of hiring. The fact the economy hasn't been incredibly weak, particularly in the U.S., means that we're not seeing much of the laying off of existing workers.

So people with job tenure are still hanging in. People who don't have that experience are struggling to get in. Again, the whole youth unemployment problem is not purely AI, but a subsegment of it may be.

Okay, let's finish with a little talk about the U.S. risk premium. U.S. long-term bond yields have been stubbornly high, higher than one might have imagined if you had known what the policy rate is, and that rate cuts have been happening, and so on.

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They've failed to decline materially even as the Fed has cut rates. We've talked in the past about declining U.S. exceptionalism, the idea that the U.S. has been a very special place and its economy therefore has grown faster and it's borrowed more cheaply and had the reserve currency and so on. But it's losing a little bit of that luster as its fiscal problems mount.

For example: big deficits, big debt, as economic policy has been suboptimal in some spaces; also declining foreign trust, the rest of the world not as trusting in the U.S. I think just given rising domestic polarization as well.

So we posited before that makes U.S. debt a bit less attractive. And perhaps this is part of the story of those longer-term yields being higher than otherwise.

I think there is some truth to that. I would still stand by that. We think that could still be a relevant investment theme going forward.

It has to be said, though, that when you look at the U.S. 30-year yield versus other peer countries, actually the bond market's been pretty enthusiastic about the U.S. and quite tolerant of it relative to other markets.

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For instance, the U.S. 30-year bond yield is about flat in 2025. It actually hasn't really gone up. In contrast, the UK 30-year bond has increased by 50 basis points; in France it’s up by 69 basis points; in Germany it’s up by 74 bps, in Japan it’s up by 79 bps. And that's even though several of those countries have been cutting rates more than in the U.S.

And so their yield curves have been steepening to a great extent. Again, the point being we do have concerns about the U.S., and we do think that investors will likely, over time, be a bit less enthusiastic about those long-dated U.S. bonds, just as a proxy for trustworthiness and so on.

But you can't actually say that's been the theme so far. U.S. yields are high, but other countries have seen their yields increase to a much greater extent. And so the U.S. actually has remained fairly exceptional in that context.

One theory, by the way, is just that as the White House pivots toward issuing more short dated bonds and fewer long-dated bonds, maybe there's a mechanical issue helping to hold down long-dated yields.

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But for the moment, investors are seemingly more than happy to continue holding U.S. bonds. We do wonder whether there might be a little bit more reluctance in the future. Not to the extent of U.S. long-term yields necessarily rising, but maybe to the extent of U.S. long-term yields not falling – even as the Federal Reserve plausibly delivers another call it a percentage point or so of easing over the next year or so.

Okay, I'll stop there. Hopefully you found some useful things, some interesting things in this update today. I thank you so much for your time and please consider tuning in again next time.