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Trump’s impact on the economy

Special

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Introduction

On January 20, Donald J. Trump will be inaugurated as the next President of the United States. In this Special we sketch the changes in economic policy that we should expect in the coming years. With the Republican Party remaining in control of the Senate and the House of Representatives, and a Republican President in the White House, the gridlock of the last six years that prevented the federal government from taking decisive policy measures is over, at least until the mid-term elections in November 2018. A substantial fiscal policy package is being discussed to raise the modest growth rate of the economy. The transition from President Obama to President Trump will also imply a major shift in energy policy. What’s more, we are likely to see a radical shift in US trade policy: instead of leading the global effort on trade liberalization the new administration intends to take measures to protect domestic industries and workers against globalization. We also discuss the implications of Trump’s economic policies for the public debt, monetary policy and financial markets.

Fiscal stimulus

President Trump intends to give the economy a boost through an increase in infrastructure spending, a reduction of tax rates, and by cutting excessive regulation that is hampering business activity. However, bills on government spending and taxation are written by Congress and can only be signed or vetoed by the President. This means that Trump will have to work with Republicans in the Senate and the House of Representatives to implement his fiscal policy plans. Trump’s tax proposals would reduce taxes for all income groups, but the higher incomes would benefit the most. This is ironic since his rise to the Republican nomination has been attributed to a revolt by blue collar voters. On balance, Trump’s tax proposals would lower tax revenue. The bulk of the loss would come from reduced business taxes. This would give the economy a fiscal impulse which would be amplified by his proposals for government spending on infrastructure and defense. However, because of the large tax cuts his proposals would probably have a substantial upward impact on the budget deficit and the public debt. The budget hawks in Congress may have some problems with that. Note that House Speaker Paul Ryan used to be one of them. Therefore, the size of the fiscal stimulus may be smaller than Trump would prefer. For example, the $1 trillion infrastructure spending spree that he proposed during his campaign may be a bit too much for the budget hawks. What’s more, the Republicans may try to squeeze in some spending cuts elsewhere to mitigate the expansionary impact of the fiscal policy package on the budget deficit.

Figure 1: Excessive regulation (NFIB)
Figure 1: Excessive regulation (NFIB)Source: NFIB, Macrobond

Since Republicans control both the White House and Congress, a deal on a fiscal policy package could be reached relatively early this year. However, it may take considerable time before the impact will be felt in the economy. First, the implementation lag of infrastructure spending can be considerable. Finding shovel ready projects can be a challenge. Second, the impact of infrastructure spending on GDP growth may also take time. Note that the $305bn highway bill of December 2015 has yet to have a positive impact on GDP growth. Third, the positive impact of the fiscal impulse may be mitigated by the negative fall-out from Trump’s trade policies. 

What’s more, Trump’s footprint on the domestic business climate is ambiguous. While deregulation should encourage business activity, Trump’s micromanagement of the investment decisions of US corporations may in the end be counterproductive. Most likely, it creates a climate of fear of political reprisal against rational business decisions. Alternatively, it could lead to corporations ‘gaming the system’ by threatening to move business activities abroad in order to negotiate tax deals or government contracts.

Trade policy

While fiscal policy is primarily made in Congress, the White House has the upper hand in trade policy issues. In our Special The Trump Trade War Game we had an in depth look at the legal powers of the US President to take protectionist measures without approval from Congress. It showed that a President Trump could start taking protectionist measures on his first day in office, which is January 20, 2017. Since the President has the authority over foreign affairs, he can cancel free trade agreements, such as NAFTA (the North American Free Trade Agreement). By proclamation, he could then raise tariffs on Mexico (and Canada) to the most favored nation (MFN) rate of 3.5%. Subsequently, without exiting from the WTO, he can use a number of ‘statutes’ to raise tariffs above the MFN rate and impose other import restrictions. These laws give the President the power to raise trade barriers to deal with current account deficits, unfair trade practices, national security threats, national emergencies, and war.

Figure 2: US trade balance with Mexico and China
Figure 2: US trade balance with Mexico and ChinaSource: Census, Macrobond

From a game theoretical perspective, these legal powers provide the President with bargaining power because they allow him to make a ‘credible threat’ against trading partners, without interference from Congress. In The Trump Trade War Game we took a game-theoretic approach to analyze the possible outcomes of a trade conflict. This game of brinkmanship has three possible outcomes: victory for the US, a tie, or a trade war. Ironically, victory for the US is positively dependent on a President Trump’s perceived “irrationality” and the rationality of the trading partner. If both act rationally it will be a tie. If both behave irrationally, we will have a trade war. We also found historical precedents of these outcomes. President Reagan forced the Japanese to ‘voluntarily’ restrain their auto exports to the US in 1980s, leading the US to victory in that trade conflict. In contrast, President George W. Bush had to revoke steel tariffs after the EU threatened to retaliate during a trade conflict in 2002-2003, which therefore ended in a tie. Finally, in the 1930s the Smoot-Hawley Tariff Act led to a full-scale trade war that deepened and extended the Great Depression.

In the event of a trade war, there will be an across the board negative impact on US domestic sectors in three phases. In the first phase, which may start on January 20, 2017, a raise of US tariffs on imports from countries like China and Mexico would hurt US importers. In the second phase, which could follow shortly, a decision by targeted trading partners to retaliate would affect US exporters. Note that while the Trump presidency could benefit the defense industry, if he were to start a trade war that could lead to retaliation by trading partners and hurt US exports of defense products. Finally, in regions with a high intensity of exporting and/or importing firms, the US services sector would in the end be affected as well as they face decreased demand from struggling clients. 

Even without a full scale trade war, the positive impact of the fiscal impulse could be weakened by protectionist measures of the new President. Protectionist tendencies could undermine world growth and backfire on the US economy.

Public debt sustainability

Assuming that Congress will to some extent support Trump’s stimulus plans mentioned above, US public debt will rise under the Trump Administration. This raises questions about its affordability in the medium term, and eventually about the US’ capacity to finance its public debt. 

High debt ratio set to increase further

The US public debt ratio is already high (108% of GDP in 2016, IMF) and poised to grow further due to unfunded liabilities in social security and healthcare programs, an ageing population and rising interest rates as the Fed continues its policy normalization in the coming years. For example, the IMF estimates unfunded pension liabilities at about 20 percentage points of GDP (IMF, 2016). Other estimates of Social Security and Medicare liabilities go as far as multiple magnitudes of the reported government debt levels (Powell and Smith, 2016). Trump’s tax plan is estimated to add another 28 percentage-points to federal government debt by 2025 (The Committee for a Responsible Federal Budget (CRFB, 2016). This would imply a rise in the generalgovernment debt to at least 136% in 2025.

Figure 3: The economy doesn’t appear to need any stimulus…
Figure 3: The economy doesn’t appear to need any stimulus…Source: Rabobank based on data from BLS, OECD and IMF

The CRFB does not take into account possible positive economic growth effects, but we expect those effects to be limited and temporary, as the positive impact of Trump’s fiscal policy is likely to be weakened by his trade policy. What’s more, given the current state of the US economy, public stimulus could lead to higher inflation and interest rates, which would hurt private consumption and investment. This results from the fact that the US will expectedly close the output gap (i.e. the discrepancy between actual and potential output) in 2017, with unemployment already under the natural rate (Figure 3). 

Public debt challenges

To interpret the challenges posed by the size of US public debt it is important to look at the affordability of the debt and the capacity of the US to finance it. Public debt is said to be affordable if current and future debt payment obligations can be met without introducing measures that substantially harm growth, welfare or quality of ongoing public services. Rating agencies suggest that debt is affordable when interest payments constitute less than 10% of total government revenue. In the US, the ratio was about 10% in 2016, despite historically low interest rates. With interest rates set to increase as the Fed continues its policy normalization in the coming years, the weight of interest payments on the budget will already increase under current policies. If we add to that the debt increasing and revenue decreasing effect of Trump’s fiscal plans, and debt affordability is clearly at stake.

In order to keep fulfilling debt obligations in the future, President Trump will either have to cut other expenditures or further raise budget deficits and thus debt - if Congress will allow him. The first option would harm domestic households and/or firms, while the second option would create a negative feedback loop of rising interest payments, rising debt and rising interest rates. Eventually, the question is if debt can be refinanced. Generally, the larger the debt, the lower the demand for newly issued bonds and the higher the interest rate to be paid. Ghosh et al. (2013) have calculated debt limits for a panel of developed countries by combining the historic primary balance reaction function with interest rate data. Depending on different ways of calculations, they argue that the US debt limit, beyond which refinancing would become problematic, lies between 160% and 180% of GDP. Remember that Trump’s tax plan is estimated to raise public debt to 136% of GDP by 2025. That said, Ghosh et al. (2013) do not take into account the ‘exorbitant privilege’ that the US has, by providing the global principal reserve currency.

All in all, Trump should worry about the affordability of the public debt, yet may have some leeway as regards his administration’s capacity to refinance the debt.

Energy policy

“American energy dominance” and energy independence is what Donald Trump promised his electorate to achieve by unleashing an energy resources bonanza. To achieve this, the president intends to use the following channels: reduce energy regulations (including the withdrawal from international commitments such as the Paris Agreement on climate change(COP21)), extend the federal acreage available for exploration, support energy infrastructure developments and facilitate innovation on all energy forms, as “the government should not pick winners and losers”. But how far can Trump go and what are the likely implications for the US energy policy and price developments?

Energy independence seems a far- fetched goal for the US as without significant investments the refining sector continues to need a certain volume of foreign heavy sour crudes as input. Nevertheless, improvement of domestic pipeline infrastructure could increase the use of local rather than imported sweet light crudes. Approval of the Keystone XL pipeline to Canada, expected under Trump, would favour imports from the northern neighbour at the expense of less reliable oil exporters such as Venezuela.

Trump has promised to revive coal by reducing regulations constraining the sector. Obama’s Clean Power Plan (CPP) implemented in 2015 seems the easiest target for being repealed. The plan is currently entangled in a legal battle, so the easiest way to prevent its implementation is not to defend it in courts. However, this is unlikely to prevent coal’s decline in the US energy mix (Figure 4). So far, the decline was mainly driven by a an almost fourfold reduction in gas prices since 2008 to levels that compete with coal in energy production. In 2015 the Mercury Air Toxic Standards, already in effect and thus difficult to repeal, led coal’s decline. Consequently, repealing the CPP would at most translate to a slower retirement of coal power generation – retirements would be 35% lower by 2030 according to EIA estimates. Gas would take the lead in power generation nevertheless.

Figure 4: US energy consumption by fuel
Figure 4: US energy consumption by fuelSource: BP Energy Statistics, Rabobank

Voiding the CPP would have some impact on renewables, as EIA estimates additions would be 23% lower without it. However, renewable energy production will keep on growing on the back of declining costs, the extension of tax credits by congress (and thus irreversible) until 2020 for wind and 2021 for solar, and supportive state-level policies. Moreover, Trump’s plan to facilitate innovation could benefit renewables most, as that is where most technological advances seem likely. Besides this, the shift of many large companies such as Google and Apple towards cleaner energy sources is unlikely to be affected by any policy changes.

The oil and gas sector, including shale exploration, is likely to benefit from Trump’s plans as lighter regulation, improved infrastructure and the extension of available federal acreage could help reduce production costs. Nevertheless, as indicated by development in recent years, international oil price development will remain the main driver. Oil prices would be affected if the nuclear deal with Iran were to collapse and exclude Iran from the oil market again. However, as the deal involved mainly EU sanctions, while US sanctions were maintained, the direct impact of US action against Iran is limited.

US climate change policy could suffer under Trump. Withdrawal from commitment to the COP21 is possible in various ways, especially as the agreement was never ratified by Congress. And that could setback global efforts to reduce greenhouse gas (GHG) emissions somewhat, but it will not bring the process to a halt. First, even without commitment to the COP21 the US economy is likely to continue on its decarbonisation path on the back of increasingly cheaper gas and renewables. The lack of climate change policy during the Bush years did not prevent the carbon intensity[1] of the economy from falling (Figure 5). Second, the agreement recognizes the sovereignty of its signatories, so a US withdrawal does not affect the commitments of other countries. And the fact that local dynamics such as air pollution and the high costs of extreme weather events are pushing large emitters like China and India (Figure 6) towards cleaner energy sources bodes well for the realisation of these other commitments.

Figure 5: Carbon intensity of the US economy
Figure 5: Carbon intensity of the US economyNote: GDP in purchasing power parity, constant 2011 prices; combustion related CO2 emission.
Source: BP Energy Statistics, World Bank, Rabobank
Figure 6: Combustion related CO2 emissions per region or country
Figure 6: Combustion related CO2 emissions per region or countrySource: BP Energy Statistics, Rabobank

All in all, Trump’s likely energy and climate change policy seems supportive to coal, gas and oil and poised to dampen the development of renewables and the reduction of greenhouse gas emissions. However, the net impact is likely to be modest as even Trump cannot beat market forces.

Footnote
[1] The carbon intensity is defined here as the volume of combustion related CO2 emissions per USD of GDP; we use purchasing power parity and 2011 constant prices GDP

Market implications

After the financial markets have projected all their hopes on the new President, he now faces the daunting task to deliver. With a Republican Congress on his side, he should be able to forge a substantial fiscal stimulus package in the coming months. However, it could take considerably more time before that stimulus accelerates GDP growth. Meanwhile, there are considerable downside risks to Trump’s trade policies which could materialize well before the arrival of the fiscal policy impulse. With so much positivity priced in by the markets at present, there is substantial downside risk to stock prices, interest rates and the US dollar during the course of the year.

Downward movements in interest rates and weakness in the dollar could be amplified by monetary policy. At present, the Fed expects to hike its main policy rate three times in 2017. The Fed’s renewed optimism – in September 2016 they expected to hike only twice in 2017 – is linked to Trump’s anticipated fiscal policy initiatives. The growth boost from a fiscal impulse would reduce the burden on the Fed and allow the central bank to remove its monetary policy accommodation more rapidly. However, the minutes of the December meeting also reveal considerable uncertainty regarding the timing, size, and composition of any future fiscal and other economic policy initiatives as well as about how those polices might affect the economy. Several participants pointed out that economic growth might turn out to be faster or slower than they currently anticipated. All in all, the Fed’s rate trajectory has become as much Trump-dependent as it is data-dependent.

If disappointing economic data force the Fed to hike at a slower pace than they currently expect, this would have a downward effect on longer-term interest rates as well, and weaken the US dollar. Note that both in December 2014 and in December 2015 the Fed’s projections implied four hikes for the next year. However, both in 2015 and in 2016 the Fed delivered only one, just before the end of the year.

Figure 7: S&P 500
Figure 7: S&P 500Source: S&P 500

Since we expect the positive impact of fiscal policy to hit the economy later rather than earlier in 2017, and mostly in 2018, while the negative impact of trade policy could hit us much sooner, we are skeptical of the Fed’s policy rate projections for this year as well. What’s more, the voting members of the FOMC are more dovish in 2017 than in 2016, now that the three hawks Esther George, Loretta Mester and Eric Rosengren – who all wanted to hike in September instead of December –, have lost their voting rights.

For now, we expect only one hike this year, most likely in December. If the fiscal policy impulse hits the economy sooner than we expect, and with more impact, the risks to our forecast lie to the upside. In contrast, if the fiscal impulse disappoints in terms of timing and size, or if trade conflicts inflict substantial damage on the US economy, the risks lie to the downside.

Conclusion

Trump’s plans to increase spending on infrastructure, reduce tax rates, slash regulation, and liberalize the energy sector should boost the economy in the coming years. However, increased government spending and lower tax revenues may also push up the public debt trajectory. This could hurt the long-term outlook for the US economy. What’s more, Trump’s trade policies could backfire rapidly and undermine the positive impact of his fiscal policy initiatives. Finally, his micromanagement of business investment decisions may have a negative impact on the domestic business climate. On balance, it seems that financial markets have priced in most of the positives and perhaps not enough of the negatives.

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Author(s)
Philip Marey
Rabobank KEO
Alexandra Dumitru
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 60441
Hugo Erken
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 52308
Maartje Wijffelaars
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 68740
Ester Barendregt
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 52312

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