Trade, Tariffs, and Taxes: The Economic Impact of the US Election

Late last week, members of our Investment Strategy Team sat down with our Chief US Economist, Eric Winograd, to get his latest thoughts on the implications of the US Election. While Eric is always humble enough to acknowledge the economic uncertainties at any given time, he did have some very thoughtful views on what may be in store. The Q&A below is an excerpt from that conversation. We posed the questions to him which we heard most from our clients during the week since Election Day.   

Eric, thanks for being with us. We now know Donald Trump will be the 47th President of the United States, perhaps with the Republican party in full control of both chambers of Congress. What policies has he discussed that are most relevant to the US economy over the next four years?

While the exact details of the policy path for the next few years remain uncertain, the topics that are of most importance to the US economy are trade policy and fiscal policy.

Trade Policy: President-elect Trump was very clear during his campaign that he intends to pursue a more protectionist trade policy, particularly with China. If that policy includes significant use of tariffs, it could have meaningful effects on the economy. Tariffs require domestic purchasers of foreign products to pay a tax on those imports. If US producers who rely on imported goods pass those costs through to consumers, it would raise the price level, and reduce the purchasing power of domestic consumers. If they do not, it would reduce corporate profits. One way or another, tariffs function essentially as a tax paid by domestic actors.

• Those who advocate for tariffs argue that increasing the cost of imports would result in substitution, as domestic production would replace foreign imports. That would likely happen to some degree, but the process would take time and cause economic friction in the meantime as production is reoriented. It isn’t always easy to rejigger domestic production to replace goods and products that were previously imported. Additionally, foreign countries would very likely impose reciprocal tariffs on US export goods. As a result, we believe that a reduction in free trade, especially if implemented through tariffs, would result in less efficient growth.
• It is important here to note the limitations of GDP as a measure of economic activity. If the trade deficit falls, GDP would rise. But the rise would not reflect domestic strength, necessarily. Reduced consumption as a result of strained household finances in the face of more expensive goods is not a sign of economic strength. So even if the net impact on GDP from trade and tariff policy might be limited, we believe that the underlying “core GDP” reflected in real domestic consumption would weaken if trade confrontations increase.

Fiscal Policy: President-elect Trump indicated during the campaign that he would push to extend and make permanent the 2017 tax cuts, which would add an estimated $4 trillion to the national debt over the next decade. He also proposed a variety of other tax cuts and incentives that would add even more to the deficit and debt. While it is reasonable to expect that not all of those programs will be implemented, nothing in the campaign suggests that the deficit or the debt will come down in the coming years. We expect persistently large fiscal deficits in the coming years, and alongside that, a consistent increase in the level of government indebtedness. That will support economic growth, as it has done for the past several years, but it may also keep interest rates elevated.

Post-election, equities have rallied and bonds have sold off (rates higher). What do those moves tell us about sentiment on the economy?

Post-election price action tells us that financial markets are anticipating a combination of corporate tax cuts and elevated fiscal spending. Corporate tax cuts, as in 2017, are likely to boost corporate profits and thus the stock market. At the same time, however, those tax cuts will increase the government deficit, pushing yields higher.

There’s a view that Trump’s immigration and tariff policies may stoke inflation—is the Federal Reserve likely to adjust their policy path given this possibility?

If inflation rises, the Fed will have to adjust its policy path accordingly: their current forecast calls for a steady deceleration in inflation over the next few quarters. In our view, tariffs are likely to increase prices, and a reduction in labor supply through tighter immigration/deportation policy would point in the same direction. That said, the Fed is not likely to move until it sees the impact of any policy changes in the data. Chair Powell was very clear in his latest press conference that the Fed “does not guess, does not speculate and does not assume” what policy will look like. They will react to the data as it comes in, but they will not change course proactively based on their read of the political situation.

How are you thinking about the impact of further tax cuts (individual and corporate)?

We believe that the primary impact of the tax cuts that the incoming administration has discussed are on financial markets, not on the real economy. Corporate tax cuts boost corporate profits and increase the federal deficit more than they spark growth or hiring. The economic multiplier of tax cuts on individuals tends to be fairly low; cutting taxes on wealthier individuals does not spark additional consumption. The real economic impact is likely to be quite small.

To what extent could deregulation (e.g., cutting red tape and becoming less restrictive on M&A, for example) unleash further growth in the economy?

Deregulation may provide some boost to growth, but recent history suggests caution. The first Trump administration pursued a deregulatory agenda, and there was no clear evidence that it resulted in a significant boost to growth. It is also worth noting that regulatory policy is in some respects a zero-sum game. If regulatory policy boosts investment in one industry, it likely hurts investment in another. Regulatory support of oil, for example, might hurt investment in greener technologies. As a result, we think it better to focus on the winners and losers from regulatory changes rather than expecting a major economic change.

How do you think Trump will reshape the FOMC when Powell’s term ends?

FOMC Chair Powell’s term as chair expires in 2026, and we expect that President Trump will appoint a new Fed Chair after Powell’s term ends. Between 2026 and 2028, he will also have the opportunity to appoint two new Vice Chairs and a new Governor, giving him significant scope to change the personnel at the Fed. During his first term, Trump’s initial appointments to the Fed were rejected by the Senate, largely because they were perceived as being too political. After that rejection, more independent candidates were eventually approved. With a more quiescent Senate this time around, that sort of restraint may not exist at this point. We believe that an independent central bank is key to a sound economy and strong financial markets, and if President Trump were to appoint people based on their political views rather than their economic and financial expertise it could pose serious difficulties for economic management. If any appointments are perceived to lack independence and to be subservient to the executive branch, financial markets would react poorly and would require additional risk premium to invest in US Treasuries specifically.

Finally, have you changed your forecasts given the election results?

Our forecasts evolve over time and there was no structural break in our thinking post-election. We have been marking up our growth numbers for several quarters in light of incoming data, and that has continued this month. We have also marked up our expectations for longer-dated interest rates as it has become clear that there is no significant constituency for fiscal restraint in the political environment. We continue to expect the Fed to cut rates and for the speed of those cuts to be determined by incoming data rather than by politics, as has been the case so far. If we see significant changes in policy implemented, that may lead us to change our forecasts somewhat more quickly than the Fed will change theirs, but given the uncertainty around the policy environment, we think it best to wait and see what develops rather than guessing as to what might be implemented.

Thanks, Eric.

Eric’s comments underscore the uncertainty that comes with forecasting at the intersection of markets, the economy, and politics. As these issues come into better visibility, we expect markets to oscillate from one day to the next and will continue to communicate as conditions warrant.