By Olivier Coibion and Nitya Pandalai-Nayar
After a long campaign, we have a clear outcome to the election: a Trump victory combined with a likely Republican majority in both houses of Congress. How should we expect this outcome to affect the economic outlook for the U.S. and the rest of the world? Yogi Bera once said “it’s hard to make forecasts, especially about the future.” But given the number of policy changes promised by candidate Trump and that President Trump will soon be free to implement, we view this as an opportune time to reflect on the main forces that we expect to see at work in coming months and years. We first consider the implications of what we view as the three most likely policy changes from a macroeconomic point of view: an increase in tariffs, a mass deportation of illegal immigrants and tax cuts. We then turn to what we view as three major wildcards: Trump’s interactions with the Federal Reserve, the implications of higher economic uncertainty, and the outlook for energy and commodity markets. Together, the likely effect of this combination of policies is to leave the U.S. economy poorer than it otherwise would have been and facing higher prices.
Tariff policy:
“The most beautiful word in the dictionary,” according to candidate Trump, is tariffs. One promise he has repeated throughout the campaign is to impose large tariffs on Chinese goods and has suggested imposing across-the-board tariffs on all imports. Given the Republican control of Congress and lukewarm historical support of Democrats for free trade, the widespread adoption of higher tariffs by the U.S. is a very likely policy outcome in the near future.
Tariffs are a tax on imports. As such, American consumers would face higher prices on Chinese products and those of other trading partners on whom we place such tariffs. The first and most direct effect from such a policy would therefore be to place upward pressure on prices. Imports are around 15% of GDP, so a back of the envelope calculation would suggest that this upward pressure is likely to be minor. This line of reasoning is problematic though because (a) indirect exposure to imports in domestic supply chains is likely to lead to larger across-the-board increases in prices, even in goods produced domestically, and (b) lower income households consume a larger share of cheap imported goods in their daily lives than richer households, so the tariff-led price increases will affect lower income consumers disproportionately.
What about possible benefits for the domestic economy? While these higher prices could lead consumers to purchase more U.S. products or induce some production to move back to the U.S., there are several reasons to be skeptical that this would increase U.S. employment much. First, we should expect our trading partners to reciprocate with their own tariffs, much as in the trade wars of the 1930s, so U.S. exporters will face lower demand for their products, reducing U.S. employment. Second, given that the U.S. is already near full-employment and inflation close to the Fed’s target, the Federal Reserve would likely respond to a tariff increase by raising interest rates to offset inflationary pressures, which would reduce aggregate employment. Third, higher tariffs would disrupt global supply chains for U.S. producers, which would likely also place further downward pressure on employment. Hence, the most likely longer-run outcome is unchanged aggregate employment but significantly higher prices overall.
Furthermore, we are likely to see inflationary pressures appear even before tariffs are put in place. Consumers and firms will respond to the expectation of higher tariffs in the future by stocking up on Chinese and other international products, before tariffs kick in, which will place immediate upward pressure on those prices (as quantities cannot adjust immediately and short-run supply is predetermined). This will raise the profits of foreign producers at the expense of U.S. consumers. U.S. firms that use these products as inputs will also likely start raising prices in anticipation of the higher costs they will face in the near future. The unanticipated pre-emptive demand for foreign goods could affect shipping costs and product availability, and potentially cause disruptions in global supply chains similar to those that we saw at the onset of the pandemic. At worst, this would tend to raise prices for all products that use internationally-produced inputs, not just those coming from countries that we might target with new tariffs. Hence, the very anticipation of future tariffs in a full-employment economy is likely to lead to immediate inflationary pressures even before the Trump administration comes into office.
Mass deportation:
The second policy that candidate Trump has promised is “the largest domestic deportation operation” of illegal immigrants. How widespread such a deportation might be, or how rapid, remains unclear but the current expectation given the language used in the campaign is that it is likely to be large-scale. What would an immediate deportation of millions of people from the U.S. imply for the economy?
First, the expulsion of immigrants would correspond to a reduction in the supply of workers to the U.S. economy, targeted toward specific industries like construction, agriculture and services: what macroeconomists would typically refer to as a “stagflationary” shock. The “inflationary” part comes from the fact that such a policy would raise the cost of production in these sectors and would therefore tend to exert inflationary pressure on houses, food products, and the service sector. The “stagnation” part comes from the fact that with fewer workers, our economy will produce less. Whether the decline is large enough to induce a recession will depend on how large the deportation turns out to be.
Second, immigrants are a source of demand for the U.S. economy, since they purchase products and services made in the U.S. A large-scale deportation would therefore tend to reduce aggregate demand, which would put downward pressure on employment of U.S. workers but also downward pressure on domestic prices.
Together, the net effect of a deportation is therefore to primarily reduce total employment in the U.S., both from immigrants and non-immigrants, leading to a sharp decline in overall economic activity. Whether prices overall end up rising or falling from this policy change will depend on which channel is most powerful, the decline in labor supply or the reduction in aggregate demand.
Tax reform:
The third policy reform that we can confidently expect from the new Trump administration is extending the sunsetting tax cuts from the previous Trump administration, perhaps with the addition of new tax cuts. Candidate Trump has proposed eliminating income taxes on tips and on Social Security benefits, for example. Tax cuts tend to be expansionary through the fact that they increase after-tax income, thereby raising employment, production and prices in the economy. The extent to which they do so depends to a large extent on the response of the Federal Reserve. Since the U.S. economy is close to full employment and inflation near the Fed’s target, an expansionary tax cut would likely be offset by higher interest rates on the part of the Federal Reserve, since Fed officials would push back against any inflationary pressure induced by a stronger labor market. We would therefore expect limited effects on both prices and employment from this tax policy. The main consequence would instead be to reduce the revenues of the Federal government. Since there have been few concrete proposals for reducing government spending by candidate Trump to offset the promised tax cuts, the lower revenues will lead to a higher budget deficit and rising U.S. government debt, continuing recent trends from the Biden and prior Trump administration. To the extent that larger deficits exert upward pressure on interest rates, we expect this policy to push interest rates even higher than they would have been otherwise.
Summary:
The net effect of these policies is therefore a combination of higher prices (coming largely from the tariff policy and tax cuts), lower employment and income (primarily from the deportation policy), higher deficits and debt (due to the tax cuts) and higher interest rates (from the Federal Reserve’s likely response to these policy actions).
However, there are a few additional possible outcomes that could affect these predictions, although these are more “wildcards” and we are less confident in how they will play out.
Pressure on the Federal Reserve:
One of the many ways in which the first Trump administration was unusual is in the public pressure that Trump applied to the Federal Reserve to reduce interest rates. Since the Fed is likely to again be raising rates to offset future Trump tax cuts and tariffs, the stage is set for another confrontation between the two. If the future administration uses Congress to change how the Federal Reserve operates or a Trump administration appoints individuals that follow Trump guidelines for monetary policy rather than those of traditional central bankers, we are likely to see the Fed lower interest rates relative to what we are predicting. This type of accommodation by the Federal Reserve of Trump policies could significantly raise inflationary pressures but offset some of the predicted declines in employment and income. In the longer run, limits to or even the abandonment of the Federal Reserve’s independence would lead to permanently higher and more volatile inflation, which would ultimately reduce the productive capacity of the U.S. economy and the real income of its workers. Because the credibility of the Federal Reserve has taken decades to build, we view the possibility of this as one of the biggest long-term risks to the U.S. economy.
Energy and commodity prices:
Inflation in the U.S. and the world fluctuates with the prices of global commodities like oil, wheat, copper, etc. To the extent that these prices are determined on global markets, the policies of the U.S. government tend to have only limited effects on them, despite what is proclaimed by political candidates during elections. Candidate Trump has promised to loosen regulations on oil production in the U.S., which would tend to reduce energy prices in the long-run, but also reduce support for alternative energies like solar, which would tend to raise energy prices. So the net direct effect of these policies on overall energy prices -and therefore U.S. inflation- is likely to be muted.
What is likely to be more important for commodity prices are developments in the Middle East as well as in the Ukraine-Russia conflict. Predicting how a new administration might affect the risk of further conflagration of conflict in these regions is outside our expertise, but we can expect these to have significant effects on global commodity prices and inflation.
Uncertainty:
The widespread implementation of new policies, combined with the ambiguity about their likely size and effect, will tend to raise uncertainty about the macroeconomic outlook, for demand, trade, inflation, exchange rates and interest rates. Higher macroeconomic uncertainty tends to reduce investment and hiring by firms, and makes households increase their savings for precautionary reasons, thereby reducing the demand for firms’ products. The overall effect of higher uncertainty on the economy is therefore quite contractionary. Given this, we expect the higher macro-uncertainty from these policy changes, as well as from Trump’s deliberate creation of uncertainty to increase his scope for negotiations, to exert further downward pressure on economic activity.
Conclusion:
Overall, our expectation is that the new Trump administration will bring with it new inflationary pressures, higher deficits and interest rates, and declines in employment and income relative to what would have happened otherwise. How severe these effects turn out to be will depend on the actual policies that are implemented (e.g. how big are the tariffs, how widespread are the deportations) and the responses of other organizations (the Federal Reserve, our trading partners, etc.). There is scope to hope for better outcomes, for example, if peace in the Middle East and Ukraine were to lead to significant declines in commodity prices. But hope is not a strategy and the potential downside risks loom large. From the possibility of the first global trade wars since the 1930s or incursions on the Federal Reserve’s independence, we could see long-lasting damage imposed on the U.S. and global economy in a very short period of time.
