Donald Trump swept into office riding a pledge to bring manufacturing jobs back to the United States through a combination of lower corporate taxes, deregulation and better trade deals that would put US companies on an even playing field with the international competition. In the world view of President Trump and his economic advisors, these policies will place the US economy on a permanently higher annual GDP growth trajectory in the neighbourhood of 3% to 4% – about double its current cruising speed.
Unfortunately, there are a number of tensions at the heart of the administration’s agenda that are becoming increasingly apparent to investors, and which in our view make it unlikely that the economy can sustain much higher levels of growth. These tensions may ultimately have the greatest consequence for foreign exchange markets and the Federal Reserve (the Fed). In addition, the imposition of import tariffs – and the probable retaliation by America’s major trading partners – remains a significant risk.
Fiscal versus trade policy
One of the main tensions stems from the interaction between fiscal and trade policy. Fiscal stimulus will only worsen the trade deficit through its effects on consumption and the exchange rate. And despite Speaker Ryan’s emphasis on deficit-neutral tax reform, we see fiscal policy as being certain to turn stimulative in the years ahead. This is because republicans have tied their future prospects to the president and his political base, making it very unlikely for them to push back on President Trump’s policy priorities. Signs of this can be seen in congressional republicans’ sudden willingness to spend money on a border wall that could cost well in excess of USD 10 billion, when before the election most of these same people viewed the wall as a poor use of funds. Republican support for new immigration restrictions that are unpopular with a significant portion of the population is another case in point.
At the same time, it is clear that fiscal prudence is not a priority for Trump. Instead, he favours higher spending on the military and on infrastructure, along with significant tax cuts for households and corporations, while not specifying any meaningful spending reductions. Although to be fair, he and his advisors fundamentally believe that their economic policies will boost growth sufficiently to prevent any widening of the deficit, even after reducing tax rates.
Deficit neutral only under heroic assumptions
The republican leadership will doubtless push back on the administration in private and may succeed in passing tax reform that is less stimulative than is currently proposed. And if the border adjustment provision gains support from the administration and senate republicans, it would provide a much-needed source of revenue to fund a portion of the proposed tax cuts. Yet by all appearances, the Ryan plan is only deficit neutral under what most economists believe to be heroic assumptions about growth and interest rates. Thus, even if the republican leadership imposes some restraint on fiscal policy, the stimulative thrust of policy is clear.
As stimulus ramps up, some of the boost to consumption will likely leak out to imports and worsen the trade deficit, an outcome at odds with the administration’s trade policy.
In addition, the higher interest rates resulting from additional Treasury issuance and tighter monetary policy will lead to the appreciation of the trade-weighted dollar, even before considering the significant exchange rates effects of the border adjustment provision. In fact, the dollar will likely strengthen well before fiscal stimulus takes effect as investors price in this eventuality. This would serve as a near-term drag on growth, and ironically, it would be the manufacturing sector and Trump’s political base that would bear the heaviest consequences.
Exhibit 1: The prospect of higher US interest rates resulting from additional Treasury issuance and tighter monetary policy may well lead to appreciation of the trade-weighted dollar – the graph shows changes in the US dollar index between February 1990 and February 2017
Source: DXY – the US dollar index, Bloomberg, as of 10/02/17
Tariffs this year?
The likely macroeconomic consequences of these policies increase the prospect that the Trump administration will resort to more direct measures to influence trade. The president is likely to grow impatient as tax reform and new spending priorities make their way through congress, and as he seeks to make good on his campaign pledge to bring jobs home.
Meanwhile, he has surrounded himself with policy advisors who share his view that tariffs are a near-costless way of resuscitating manufacturing employment, or at least achieving more favourable trade terms.
Furthermore, over the decades, congress has delegated away significant authority to the executive branch over tariffs, providing the president with a range of protectionist options. Putting these factors together, there is a meaningful chance that the administration will move forward with tariffs at some point this year, which is very likely to spark retaliation from trade partners and a significant deterioration of risk sentiment in global markets.
Even if tariffs are kept on the back burner for the time being, it still does not guarantee positive policy outcomes. Trump and his appointees have already criticised the exchange rate policies of major trade partners, and Treasury nominee Mnuchin commented in his congressional hearing that dollar strength may have “some negative impacts on our ability to trade.” If expectations for fiscal stimulus or monetary policy tightening serve as a catalyst for dollar strength, these types of communications will only become more frequent and empathetic. Tensions could escalate to the point of foreign exchange intervention to weaken the dollar. This is certainly not our base case, but the stated policy preferences and market views of the administration mean we need to consider this and other scenarios once thought to be so far out on the tail of risk distribution as not to warrant serious thought.
Unenviable choices for the Fed
Finally, with the exchange rate as a flash point, the Fed will not be able to remain outside the political fray. If trade and currency tensions escalate to the point of intervention, the Fed will find itself in the uncomfortable position of having to decide whether to participate alongside the Treasury, using its considerable balance sheet capacity to fund that policy.
Even before the situation gets to this point, Chair Yellen or her successor will face considerable pressure to refrain from policy tightening in support of the administration’s trade agenda. The choices for the Fed are unenviable – bow to political pressure and risk a considerable inflation overshoot, or continue to tighten policy and risk more immediate constraints on independence.