Fears of an Inflationary Bust in the US ….
Financial market’s fear that President Trump’s economic policies could launch a new wave of inflation, necessitating higher interest rates and possibly triggering a budget deficit crisis and global recession. In the weeks before the election the US 10-year Treasury yield – in a dollar-based reserve currency system, the global economy’s most important market price – rose from 3.6% to just under 4.5% as markets (unlike the pollsters and mainstream media) anticipated a Trump victory. As astute an observer as Stan Druckenmiller, the world’s most successful hedge fund manager, expects US inflation to rise to at least the 4-5% range and thus the ten-year yield to increase to 6-7%. Interest rates around the globe would be dragged higher, with devastating consequences in a highly indebted world. In the UK, Labour’s economic plan – already battered – would be blown clean out of the water. Trump’s policies are seen as inflationary because he plans tax cuts when the US budget deficit is already excessively high at around 7% of GDP and proposes a 60% tariff on all Chinese products sold to US companies and 10%-20% tariffs on all other imports. Trump has also threatened to sack the Chairman of the Federal Reserve and/or give a role for himself in setting interest rates – he wants them lower. Pessimists also point out that, unlike in 2016, Trump controls both houses of Congress and has a strong popular mandate so has a freer hand to act than in Trump 1.0.
…. May be Wide of the Mark
That’s the potential bad news. The good news is that there are many grounds for believing this view is too pessimistic. A better outcome is suggested by the following:
- Similar fears were expressed in 2016, when Trump also proposed major tax cuts and tariff increases and attacked the Fed. In practise, inflation during his first term was low, averaging only 1.9% 2017-20. Tax cuts were enacted, but aimed at promoting private sector investment and tariff increases were lower than feared. Trump also re-negotiated and extended the NAFTA trade agreement between the USA, Canada and Mexico, having originally threatened to scrap it. It has become a cliché now to describe Trump as “transactional”, but his first Presidency illustrates this in spades. His outlandish statements are mostly aimed at influencing negotiations, and his actions are generally more balanced than his rhetoric. In this vein, it is unlikely that he will sack Fed Chairman Powell or enact legislation to give himself a say on interest rates. Instead, he will wait until early 2026 when Powell’s term ends and appoint a new chairman more to his liking.
- It is true that Trump has greater power than the first time around. He is also better prepared than in Trump 1.0, with a larger and stronger team around him. Appointments to office are being made much more rapidly than before. He clearly dominates the Republican Party, but there are still significant numbers of free traders and fiscal conservatives in the Senate and House who oppose bigger budget deficits and dangerous tariff rises. His main tax objective is likely to be rolling over his 2016/17 tax cuts, which otherwise expire at the end of 2025 and which the Democrats intended to scrap. Further tax cuts are likely to be dependent on achieving significant cuts in Federal spending.
- This brings us to the role of Elon Musk, who played a prominent part in the election campaign and has been appointed joint-head of a new Commission called the Department of Government Efficiency (DOGE). DOGE will review all Federal spending and regulations. Musk claims that $2 trillion can be cut from the Federal Budget – this would be a reduction of almost 30%! Given that 14% (and rising) of Federal spending consists of interest payments, and about 65% consists of mandatory payments, this is a wild claim of Trumpian proportions. Nevertheless, this appears to be a deadly serious attempt to radically reform the role of the state. Some government departments may be drastically slimmed down or abolished. The co-head of DOGE, Vivek Ramasamy, is a former Republican presidential candidate, highly successful entrepreneur, and strong fiscal conservative. These appointments are the actions of a man aware that current US fiscal policy is unsustainable. What greater legacy could he pass on than to put the US back on the path of fiscal sustainability? Trump is also acutely aware that the high inflation of the Biden years was a crucial factor in his election victory. A repeat would be a disaster for his second Presidency.
- Deregulation was a successful feature of Trump 1.0, contributing to the relatively high US growth rates of the period. Trump’s strong power position is likely to see DOGE initiate a stronger deregulation drive in Trump 2.0 that increases growth and reduces inflation by boosting the supply side of the economy. Most notable of all will be wholesale abandonment of growth-inhibiting net-zero targets, and increased incentives for oil and gas drilling- “drill, baby, drill”. US energy prices will become even more competitive, and the US will cement its position as the world’s largest exporter of oil and gas.
- Markets seem unduly complacent about shorter-term US economic prospects. Recent GDP growth of around 2.5% has been inflated by an extraordinary expansion of Federal spending, most notably subsidising “green energy” projects. This fiscal impulse is now coming to an end. There is a common misperception that high fiscal deficits continuously boost the economy, whereas the stimulatory effect is a one-off. Although the Fed has begun cutting rates, monetary policy remains restrictive. The Fed Funds rate is significantly positive in ‘real’ terms and the Fed continues with QT (selling bonds) Although the nominal Fed Funds rate is not high by historic standards it is arguably too high for a heavily indebted economy. The current level of the Fed Funds rate – adjusted for the level of US public and private debt – has always been followed by a recession. Other indicators – yield curve movements, collapsing heavy truck sales and rising unemployment – also suggest a markedly slowing economy. If this is so, fears of rising inflation and higher interest rates will quickly dissipate.
- The threat of higher inflation from tariff increases is also overblown. President Trump threatens tariff increases to extract concessions from trading partners, so they may well be negotiated down or away altogether. Tariffs also cause a one-off rise in prices and not an inflationary process unless accompanied by a significant loosening of monetary policy. The proposed tariff increases on imports from China clearly have strategic and political motives as well as economic ones, so are more likely to go ahead. China has built up massive excess capacity so that its export prices have been falling for many months, thus exerting a strong deflationary force on the global economy. Tariff increases on Chinese goods will thus counteract that force but are unlikely to start a new wave of inflation, particularly as they will weaken the already struggling Chinese economy.
Conclusion
In summary, fears that Trump 2.0 will see a new wave of inflation and a damaging rise in global interest rates seem overblown. Next year is more likely to see a weaker US economy as fiscal policy tightens and the lagged impacts of restrictive monetary policy take effect. The US economy should then recover strongly in response to better control of federal spending, lower interest rates, growth incentivising tax cuts, the lessening of net zero restrictions, a major deregulation drive, continued re-industrialisation and rising oil and gas production. I confidently expect the US economy to be the fastest growing economy in the G7 in the next five years. This implies a stronger $ over the period, especially if – and it is a big if – Trump oversees peace agreements in the Middle East or in Ukraine . The Chinese economy increasingly looks to have begun a long period of deflationary stagnation along the lines of Japan since 1990, albeit from a much lower baseline. The EU – with its German engine mired in structural decline – shows no sign of being able to escape from its low-growth/stagnation cycle, hidebound by the Euro straitjacket, political disunity and an anti-innovation and anti-enterprise mindset. Furthermore, both the EU and especially China are in the early stages of irreversible demographic decline.
Implications for the UK
A US slowdown in 2025 will mean lower US interest rates and thus UK Bank Rate can continue to be cut next year. If the USA generates a sustained non-inflationary recovery thereafter this will boost UK exports in what is by far our biggest export market. UK exports to the US in 2023 were $186bn, compared to $63bn in exports to Germany, our next biggest export market. Furthermore, the Trump administration is keen to reach a free trade agreement (FTA) deal with the UK. Much preparatory work has already been done and talks could resume very quickly. Do Starmer and Reeves have the vision and courage to seize this rare opportunity? They must not follow the advice Andrew Bailey, BoE Governor, that improving trade with the EU is the better growth opportunity. Seriously? The UK already has a tariff and quota free FTA with the EU. Bailey himself pointed out that the US economy is far more dynamic and productive than the EU. Since 2008 the US economy has grown twice as fast as the EU – 2% p.a. compared to 1% p.a. – and India has grown six times faster. Trump 2.0 could well see the US growing at 3.0% or more, and India shows every sign of continued rapid growth, while the EU will struggle to maintain its 1% growth rate. Both the USA and especially India also have far better demographics – i.e. growing populations – than the EU. His unwise (the politest adjective I could come up with) counsel is a low point in his notably undistinguished tenure. It is encouraging that Labour has not followed the EU in threatening retaliatory tariffs in response to Trump’s tariff proposals. It is even more encouraging that the government has announced that trade talks with India are to be resumed in the New year. Since a deal was close before the election final agreement could be reached quite quickly. Resuming trade talks with the US as well would be a major re-set of Labour’s very rocky start to economic policymaking.
Readers will have observed that the Trump 2.0 economic programme – business tax cuts, radical deregulation, major cuts in public spending, increased oil and gas production, and backtracking on net zero – is the exact opposite of Labour’s economic approach. I have described in recent articles* why I think the Starmer/Reeves economic plan is doomed to failure. If the US economy does significantly outperform the UK in coming years Labour will come under increasing pressure to change course. The greatest need for change might be in the highly impractical and damaging rush to net zero targets. UK electricity prices for businesses are by a big margin the highest in the developed world, and Ed Miliband’s policies will drive them even higher, putting many UK businesses under intolerable pressure. If Labour does not change course the UK’s centre-right parties may be able to use Trump 2.0 as a template for future policies, using rising US prosperity as evidence and learning from its failures as well as its successes.
Robert Lee is a former investment manager and economist
* “Is Labour already sowing the seeds of another economic crisis?”, “Ed Miliband’s energy policies could bring the government down”, and “The UK economy is now at high risk of recession”.
