Paul Carroll
Things are so crazy in Washington DC these days that I can’t ask you for the sorts of precise predictions on inflation, GDP, prospects for the insurance industry, etc. that we usually discuss. What passed for U.S. economic policy this morning could be rather different by this afternoon. So I’ll ask you, more generally, what key trends we should watch out for in terms of the effects of tariffs and in terms of the broader economy.
Michel Léonard
Yes, while our conversations are generally pretty evergreen, I’ll note that we’re talking on March 7th at 1:00 PM Eastern time, which is relevant given yesterday's announcement about suspending some tariffs on Canada. Let me outline where we stand and the key baselines we should consider.
Regarding the economy, while growth has been diminishing, the economy has remained resilient. The key question now is whether this resilience is sufficient to survive the current instability and uncertainty. As of this first quarter, I believe we still have enough GDP momentum to weather what we're seeing now, even if these conditions continue for a full quarter. However, the risk of GDP contraction rather than growth is certainly present.
On inflation, we've seen it coming down to sustainable levels, which we define as 2% to 3%. The Fed has indicated it will tolerate inflation up to 3% before taking action. Looking at the baseline for interest rates and monetary policy over the next year, the trend line remains accommodative, with two main concerns: inflation resulting from tariffs and potential policy misjudgments.
As [former Fed Chairman Alan] Greenspan used to say, the medication must fit the disease. It's important to remember that rising interest rates are effective when inflation is driven by consumption. Higher interest rates can drive down demand. However, when inflation is driven by tariffs or other factors related to consumption, raising interest rates doesn't work.
We're likely to see inflation hovering between 2.5% and slightly above 3%, without factoring in geopolitical risk. Continued geopolitical risk will put upward pressure on inflation.
Looking at the big picture for the economy, I still see this year being resilient, ending with flat to slightly positive growth.
Paul Carroll
The Atlanta Fed recently forecast a potential 2.5% to 3% annualized decrease in GDP for the first quarter. Is that an outlier, or might that be correct?
Michel Léonard
When considering benchmarks for comparison, I think back to the first year of COVID, when we faced tremendous uncertainty around March 2020 regarding GDP projections. Firms like JP Morgan and Goldman were suggesting potential contractions of up to 30% -- numbers that were unprecedented but that made sense given the unique circumstances.
We're again in an environment of extraordinary uncertainty. We may be getting tired of describing everything as unique and new, but this situation truly is, perhaps even more so than before.
At this point, I don't think we can clearly distinguish where performative policymaking ends and where the real impact on growth and growth expectations begins. Just yesterday, we saw another 30-day postponement in the imposition of tariffs, and there's fatigue around that. The market today is hovering flat after one of the worst weeks in a year, and there's fatigue there, too, as we would expect. While I traditionally focus on the real economy as an economist, my current concern is market sentiment.
The resistance in the market that keeps prices from going even lower stems from those of us who remain optimistic about growth this year -- and there are fewer and fewer of us on the optimistic side. Each time there's a performative announcement, the market's recovery within the following days becomes less robust.
That exhaustion could lead to the Atlanta Fed's -2.5% projection happening for the full year, but that would require a very significant correction in this quarter and next quarter, and I don't think we're there. I don’t think that sort of contraction in the first quarter alone is possible.
Paul Carroll
How much do you think Trump’s tariffs could drive up replacement costs, which have been such an issue for insurers in recent years?
Michel Léonard
Double-digit tariffs are not marginal adjustments. They're not about moving production -- they're about stopping production entirely.
Let me break this down step by step. First, as a baseline, we can look at what we experienced during COVID. Certain segments of the economy and insurance were particularly affected -- especially the auto sector. Due to supply chain issues, used auto prices soared. Interestingly, autos and motor vehicles are also key targets of potential current and future tariffs, so there should be some parallel with the COVID situation.
The impact of tariffs is already visible through uncertainty alone. People are already changing their purchasing decisions regarding cars. For example, in Canada, buying patterns are shifting. I'm originally from Canada, and my brother, who owns two American cars and was considering a third, suddenly changed his mind about buying another American vehicle. Similarly, bourbon producers in Kentucky are seeing demand drop because Ontario's liquor board, the world's largest buyer of alcohol, followed by Quebec, is already making different purchasing decisions.
For motor vehicles, we will inevitably see a significant drop in underlying growth, even if tariffs are suspended indefinitely, because the uncertainty is already present. This affects replacement costs for parts and repairs, though less so for labor. During COVID, replacement costs for motor vehicles -- both personal and commercial -- rose around 60%, largely due to used auto prices. I could see this happening again, following a similar timeline.
Ultimately, I believe we'll retain some version of Auto Pact, the predecessor to NAFTA. We'll likely end up with a cosmetic renegotiation -- remember, the current North American free trade agreement was negotiated by President Trump. The real question is timing -- whether it takes one month, three months, or six months. Insurance underwriters and industry professionals should be prepared for increases that could approach those COVID-era numbers for motor vehicles, the longer this situation persists.
And these double-digit increases in tariffs on lumber, auto parts and other materials don't just mean higher replacement costs – they mean many materials aren't available through the supply chain.
During COVID, lumber was still available, but we just couldn’t get auto parts and used cars. Now, we need to anticipate that goods will be stuck in transit at borders, creating significant delays. For people on both sides of the transaction – whether it's carriers handling rebuilding and repairs or homeowners getting their properties repaired – the issue is going to be time. We'll likely see more delays and uncertainty than we did during COVID.
Paul Carroll
I suspect we’re just getting started on the effects of these policy changes and all the uncertainty that surrounds them. Even if Trump’s protectionism proves short-lived – and I’m not sure it will – companies will have to rethink their global strategies. That could cause major changes to supply chains… and the companies that insure them.
Michel Léonard
As an American who immigrated from Canada, I've been shocked by how seriously other countries are taking these developments on protectionism. Those of us looking at this professionally know these are serious issues, but we also see a performative form of policymaking.
Those of us in the U.S. lived through the changes during the first Trump term, but it doesn't seem the rest of the world experienced it the same way we did. I've been surprised by that, and I think it's significant in terms of the damage done. It's quite difficult to imagine that the same level of trust will remain, for better and for worse.
There are certain areas where change is good, and even if it's constructive destruction, sometimes it is useful. But I do think there is a great deal of damage.
Paul Carroll
Do you see any historical parallels to what we’re going through?
Michel Léonard
What we're facing is potentially comparable to Margaret Thatcher's first two years as prime minister in the U.K. When Thatcher came in, she cut government spending, privatized industries, and moved extremely rapidly. She was actually on track to lose her position until the Falklands War came about and allowed her to recover politically. During this period, the U.K. experienced one of the deepest recessions since World War II.
That's the kind of economic pain we could be talking about here, but potentially on an even larger scale because it's the U.S. The agenda we're seeing now is even more transformative. The individuals involved in the current administration are much more like outsiders compared with those in Thatcher's administration, which makes this an even more striking parallel.
We're potentially looking at unemployment reaching high single or double digits, which in the U.S. has rarely happened since the Great Depression. This is why I'm concerned about the scale of transformation. We're not just looking at a typical stock market correction of 5% or 7% -- we're potentially looking at something that combines the impact of all previous corrections together.
I haven’t given up. I’m still an optimist. But the potential implications go far beyond simple replacement costs, and that's what makes this situation particularly challenging.
Paul Carroll
Thanks, Michel. Fascinating, as always.
