One has to pity Jerome Powell, the Federal Reserve head. At a time when he is trying to secure his legacy by resolving the country’s inflation problem, to which he contributed by an ultra-loose monetary policy, not only does he have Donald Trump breathing down his neck calling for low interest rates. Mr. Trump is more than likely to exacerbate the inflation problem with his proposed budget-busting tax cuts, his aggressive import tariff program, and his intention to deport around 10 million undocumented immigrants.
In that context, today’s decision to cut interest rates by only 25 basis points rather than 50 basis points is to be welcomed. We also must welcome how the Fed is managing expectations for next year ahead of Mr. Trump taking office. The Fed is doing so by signaling that it now believes it will only make two interest rate cuts next year rather than the four it had earlier penciled in. By so doing, it seems to be laying a stake in the ground to protect itself against the likely intense political pressure to which it will be subjected next year to lower interest rates quickly, even as inflation increases.
An essential reason for welcoming the Fed’s more hawkish policy stance concerning future interest cuts is that the incoming Trump administration is committed to cutting taxes on a big scale. Among Mr. Trump’s campaign promises were the extension of the 2017 Tax Cut and Jobs Act and eliminating taxes on social security benefits and tips. According to the Committee for a Responsible Budget, over the coming decade, those tax cuts could add around $ 7 ¾ trillion to the public debt.
At a time when he is trying to tame inflation, the last thing that Mr. Powell needs is a budget policy that will add substantially to aggregate demand. Yet that is what the Trump budget will likely do next year. It will do so by promoting investment through corporate tax cuts and increasing consumer spending by putting more money into people’s pockets by exempting social security benefits and tips from income taxes.
Mr. Trump’s proposed shift to an aggressive American First trade policy and his proposal to deport 10 million undocumented immigrants will also add to inflation, at least on a one-off basis. Goldman Sachs estimates that a 60 percent tariff on all imports from China and a 10-20 percent import tariff on all imports from the rest of our trade partners could add around one percentage point to inflation. Meanwhile, the Peterson Institute for International Economics believes that Mr. Trump’s deportation plan could add 3.5 percentage points to inflation by 2026.
While the inflation risks from Mr. Trump’s proposed economic program have received much press attention, there has not been much focus on the risk that his highly protectionist trade policy could provoke a world economic recession that could reach our shores. Heightening this risk is the fact that the Chinese economy is already in trouble due to the bursting of its housing bubble, the German economy is showing every sign of having run out of momentum, and the French economy is suffering from an unsustainable public finance position at a time of political ungovernability. The last thing these economies need is a body blow to their export sector from high US import tariffs.
A U.S. $100 dollar bill is seen December 17, 2009.
In short, Mr. Trump’s proposed economic plan poses clear risks to inflation. It also has the potential to trigger a world economic recession through Smoot-Hawley, such as import tariffs. In these circumstances, Mr. Powell is to be commended for exercising caution at today’s Federal Reserve meeting by limiting himself to a 25 basis point interest rate cut and signaling a slower pace for next year.
About the Author: Desmond Lachman
American Enterprise Institute senior fellow Desmond Lachman was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging-market economic strategist at Salomon Smith Barney.
