Equity markets have reacted very positively to the presidential election as probably many assume that a new Trump administration will be more lenient in terms of regulation than a Democratic administration while the potential of tariffs could benefit domestic companies’ pricing power as it will tend to limit competition from foreign producers. At the same time, the yield on the 10-year Treasury surged to about 4.4% just after the election, even though it has come back down close to pre-election levels recently.
Meanwhile, the Federal Reserve’s (Fed) reaction to the election was muted, with the Fed statement after the end of the Federal Open Market Committee (FOMC) not mentioning the election and the Fed proceeding to lower interest rates by 25 basis points as it was expected. Although the Fed Chairman said that Tuesday’s election had no bearing in the Fed’s decision to lower interest rates by 25 basis points, there is no way we can gauge whether that is true or not. We will have to wait until the December meeting of the FOMC and the release of the Summary of Economic Projections to see how the election result could affect monetary policy going forward.
Markets have already taken notice and instead of pricing 4 to 5 rate cuts in 2025, as they were before the election result, they are now pricing only two rate cuts for next year, perhaps expecting higher price pressures due to the potential implementation of broad-based tariffs, or stronger economic growth, etc.
Expect The Stagflation Discussion to Resurface
We know that the majority of economists, including us, were wrong in forecasting a recession last year on the back of very high interest rates from the Federal Reserve. However, we were correct in dispelling any fear of stagflation; that is, a combination of low economic growth and high inflation. In fact, the US economy has been the best-performing economy globally since the recovery from the pandemic recession, even if Americans continue to think the economy is in bad shape, as demonstrated by the results of the election. Although we are not going to argue with that view, that does not change the fact that the performance of the US economy over this period is second to none.
To explain what we mean, here is an example about the US dollar, which we have written about many times in the past, that may help clarify our position. We always get asked why the US dollar, even if its value has been affected by inflation over the decades, continues to be the best currency in the planet and our answer is very simple: The dollar has held its ground against the rest of the currencies in the world and has beaten every one of them over the decades, cementing its preeminence in the minds, pockets, and portfolios, of those who hold the greenback year in, year out. Those that talk down the dollar seem to not understand that the dollars’ worth cannot be taken in a vacuum—it has to be taken in the context of other currencies.
The same is true for the US economy. It is true, inflation has put Americans on the defensive and the majority of Americans are discontented with what has happened over the last several years, but once you start shopping around and see what is happening around the world, you conclude that the US economy has continued to outperform the rest of the economies in the world, even if, for Americans, that is just a non-important consolation price!
Now, let us go back to the stagflation issue. Back when we were expecting a recession to hit, we were not concerned with stagflation because recessions typically are ‘good’ for inflation, so to speak. If we have a recession, the rate of inflation is going to drop considerably and if the recession is deep enough, then we may even have a period of deflation, which means that the overall price level would decline. But what happened with the post-pandemic recovery was that economic growth was very strong, motorized by large income transfers from the federal government at first and then by government spending brought about by the three fiscal acts, the CHIPS Act, the IRA, and the Infrastructure Act. Thus, during the last several years we had the inflation part of ‘stagflation’ but not the stagnant part of the word.
But now, the story may be different. Depending on what the Trump administration’s policies are regarding tariffs and when, and how, they are implemented as well as whether the GOP wins the lower house of Congress and changes of the three aforementioned fiscal acts, we may be facing lower economic growth and a temporary surge in inflation. While this is not our base case scenario, if President Trump were to impose the entirety of the proposed tariffs during the campaign, this could push prices, and thus inflation, higher. In order to bring down inflation the Fed may decide to slowdown the process of lowering interest rates, which is what markets seem to be implying today, and/or, if inflation increases considerably there is even a possibility for them to start increasing rates again. Furthermore, if this is accompanied by changes or the elimination of the fiscal bills mentioned above, then we may be facing very low economic growth at the same time as inflation could be moving up due to tariffs.
Of course, we don’t know how the new Trump administration is going to approach its policy proposals on tariffs, and we may see the administration using the tariff threat to gain some advantage during negotiations with other countries. Thus, we will have to wait and see the scope of the proposed measures in order to figure out the path forward. Our GDP forecast remains unchanged for now, with some of Trump’s policies supportive of growth, including lower taxes as well as the extension of the 2017 tax changes. On the flip side, the risk of broad-based tariffs provides upside risk to our inflation forecast for 2025. This could weaken consumer demand as well as economic growth, and thus soften the impact of tariffs.
Markets, on the other hand, seem to have figured out everything and are already moving ahead with their repricing of Fed cuts next year. We will have to wait and see what the new administration policies are going to look like to gauge their potential effects on Fed policy, inflation, and economic growth.
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