Inflation may become a bigger problem for the U.S. economy if the policies of Republican Donald Trump lead to bigger government spending and wage pressures, writes Edward Luce in the Financial Times.
The Federal Reserve would then have to respond to inflation by hiking interest rates more than Wall Street economists now expect, he says. With Republicans controlling both houses of Congress and the White House, lower taxes and greater federal spending are almost assured.
"Before Mr. Trump’s victory, the Fed signaled it was likely only to increase rates three or four times before 2019," Luce writes. "That was because it anticipated continued fiscal retrenchment. Mr Trump’s victory has blown that up. A unified Republican government is poised to bring about the fiscal stimulus that it has been blocking Democrats from carrying out for years."
During the campaign, Trump promised $5.7 trillion in tax cuts and $1 trillion in infrastructure spending. His victory on November 8 led to a stock market rally about 6 percent as investors expected more economic growth and fewer regulatory burdens on businesses.
“But the seeds to the reversal of the ‘Trump trade’ are already sown,” Luce says. “The biggest threat will come from the U.S. Federal Reserve. On Wednesday, Janet Yellen, the Fed chair, will almost certainly raise U.S. interest rates for only the second time in a decade.”
The Fed last year raised its target interest rate by 0.25 percentage point after holding it near zero percent since 2008, when the financial crisis led to the worst economic slump since the Great Depression. Investors forecast that the Fed will raise rates by another 0.25 percentage point when it meets this week.
After last year’s rate hike, the U.S. stock market sold off by more than 10 percent by February.
If inflation is a bigger problem, the Fed may have to step in with more rate hikes to cool growing wage pressures in an overheated economy, Luce says.
“Since U.S. unemployment is already well below 5 percent, Ms. Yellen will have little choice but to accelerate the Fed’s planned interest rate increases,” he says.
Trump’s fiscal policies are still largely unknown, and he may have to compromise on his campaign promises to cut taxes and raise tariffs on products shipped from China and Mexico.
“The temptation to undermine the Fed’s independence, make a scapegoat of China, revive talk of deporting immigrants and slap tariffs on Mexico will grow with the trade deficit,” Luce says. “At which point the markets will recall what it was they originally feared about Mr. Trump.”
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