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By Andrew Kenningham, Capital Economics
A few hours after Donald Trump’s election victory last November, US equity markets and Treasury yields began to rise, and they continued on an upward trend until early 2017. Investors appeared to be optimistic that Trump’s plans for tax cuts and deregulation would help to boost economic growth, and that this in turn would lead to higher inflation.
Since Trump’s inauguration, the euphoria has faded, but equity markets have held onto most of their gains, and Treasury yields have remained much higher than they were before the election.
So are investors right to expect a Trump boom?
Tax cuts and deregulation
It now looks as if any fiscal stimulus will be much smaller than originally expected. The White House’s conflict with Congress over issues such as healthcare reform and funding for the Mexican border wall suggest that Trump will find it difficult to get agreement on his tax cuts and infrastructure investment plans.
Having promised something ‘phenomenal’ on tax policy, all he's delivered is a 250-word summary of his plans. Tax cuts will probably be smaller than hoped, and are unlikely to be passed until 2018.
Deregulation will probably not help the economy much either. Trump promised to repeal the Dodd-Frank bill that set higher capital and liquidity requirements for the banking system. But there is little evidence that these regulations are holding back bank lending, so repealing them would not greatly boost investment or consumption.
Economics trumps politics
Fortunately, the outlook for the US economy is fairly bright, regardless of Trump’s policies. US growth stalled in the first three months of 2017, but that seems to reflect temporary factors, including some unusual weather conditions, rather than being the start of a lasting downturn. Business and household surveys point to a rebound in the second quarter.
Both the main drivers of economic activity – household consumption and investment – look set to rise steadily.
Households have good reason to increase their spending because the economy has continued to create large numbers of new jobs, reducing the unemployment rate to its lowest level since 2007.
The combination of steady economic growth and exceptionally low interest rates is encouraging businesses to step up their investment.
After a couple of tough years, the shale oil industry has bounced back. There has also been a sharp pick-up in residential investment due to the improved economic outlook and backlog of demand for new properties.
Overall, the US looks set for economic growth of around 2.5 per cent this year and next. While that is not as fast as the pace reached in the late 1990s, it is above the 1.5 per cent rate achieved last year.
Three potential risks
Needless to say, there are risks to this relatively rosy outlook. I would like to highlight three.
1. Will the Fed spoil the party?
The first is that monetary policy tightening by the Federal Reserve may choke off the recovery. Interest rates have been at rock-bottom levels since the end of 2008, but the Fed has now begun to raise them.
Members of its policy-setting committee, the FOMC, have said that they expect to raise their key policy rate from below 1 per cent at present to nearly 3 per cent by the end of 2019.
However, my assessment is that this risk is not too worrying at present. Interest rates would still be low by past standards. And both household and corporate debt burdens are much lower than they were a few years ago, meaning the cost of servicing these debts should be manageable. What’s more, if the recovery stalled, policy-makers would postpone or scale back their interest-rate hikes.
2. Protectionist threat
The second threat is that one of Trump’s key policies actually damages economic prospects. So far, proposals to label China a currency manipulator, to walk away from NAFTA (North American Free Trade agreement), and to impose huge tariffs on imports from emerging economies have come to nothing. Instead, the US has limited itself to measures targeted at sectors such as steel, aluminium, and lumber, which have limited implications for the wider economy.
Looking ahead, if Trump’s approval ratings (and the economy) slump, he may dust off his campaign promises ahead of the 2020 presidential elections and pursue a much more protectionist agenda. And if other governments retaliate, the result would be a global economic slowdown, which would drag the US down with it. So this risk – although not particularly likely – is definitely worth keeping an eye on.
3. An external shock
The third risk is an external shock. One of the reasons for US economic prospects being relatively bright in 2017 and 2018 is that the rest of the world economy is recovering. Business surveys and official GDP data show that growth has picked up even in the euro-zone and Japan, which were previously struggling. Fears of deflation have largely passed. And even world trade volumes have been picking up.
Nonetheless, a problem in the rest of the world could yet derail the US recovery. Among other things, the euro-zone crisis could flare up again, fears of a Chinese devaluation could resurface, or a geopolitical crisis in the Middle East could lead to a sharp rise in oil prices. My assessment is that these external risks are the most likely cause of a downturn in the US in the next year or two.
The big picture still bright
Overall, the outlook for the US economy looks fairly bright – despite, rather than because of, Trump. The global financial crisis, which began in the US property market 10 years ago, is largely over; public and private debt burdens have been reduced; and the labour market is almost back to full employment. Against this backdrop it is likely that the US economy will expand at a steady pace and both inflation and interest rates will rise, but only gradually.
While there are always risks to keep investors awake at night, they look like less of a concern today than they have during most of the past few years.