While the market has clearly taken the Trump presidency in stride, expecting that a deluge of debt-funded fiscal stimulus will be beneficial for risk assets, and ostensibly, the US economy, one question we have posed for the past two weeks is just how viable is another debt-funded growth spurt in the longer term. And, over the weekend, this is the question that Goldman's economists, Alec Phillips and Sven Jari Stehn, likewise asked when reviewing both the short and long-term consequences of the implementation of Trump policies.
As Goldman frames it, "President-elect Trump’s proposals, if enacted, would have significant implications for the US economic outlook over the next few years, some positive and some negative. The positive fiscal impulse from his tax reform and infrastructure proposals could provide a near-term boost to growth and, depending on the specifics, could have positive longer-run supply side effects. However, other proposals could lead to new restrictions on foreign trade and immigration, which could have negative implications for growth, particularly over the longer term. President-elect Trump must also make several Fed appointments over the next year, which raises the possibility of somewhat tighter monetary policy than under current Fed leadership."
As a reminder, Trump’s three most important fiscal proposals are his tax reform plan, an infrastructure program, and his plan to boost defense spending. Trump’s tax reform plan would reduce the top marginal rate from 39.6% to 33%, and the corporate rate from 35% to 15%. While there is no official estimate of the tax revenue reduction associated with his proposal, estimates by the Tax Foundation suggest an average revenue reduction of 2.1% of GDP over the next ten years, or just over $400bn in 2017, with a roughly $250bn reduction in individual income taxes and another $160bn reduction in corporate income taxes. We provided a simple snapshot analysis of what Trump's policies would mean for individual and corporate taxpayers in a previous post.
On the infrastructure side, Goldman explains that it may also run through the tax side of the ledger. Two of Mr. Trump’s advisors recently published a plan that would seek to incentivize the private sector to increase investment in infrastructure projects that would be supported by future fees, such as tolls. They suggest that 17% of the initial investment could be financed with equity and the remainder with debt. The government would then provide a tax credit equal to 82% of the equity to reduce the cost of financing, or $14bn in tax credits for every $100bn in investment. The most important question regarding this plan is how much of the infrastructure investment would be incremental, and how much would simply replace existing municipal debt-financed investment. For ease of analysis, we consider the tax credit as a corporate tax cut, and assume the plan is successful in generating as much new investment as its authors suggest, though this could overstate the plan’s effects. We also note that while most of the focus has been on the tax credit-based plan, new material on Mr. Trump’s transition website on infrastructure refers only to a $550 billion investment, with no other details.
Mr. Trump also proposes to eliminate the defense spending cuts under sequestration, which would increase defense spending by about $40bn per year. However, he also proposes to reduce domestic spending in other areas, which would offset the defense spending boost and would result in little net change in federal spending.
To asses the full impact of the various Trump policies, Goldman then considered the effect of the combination of these policies, in three scenarios: a “full” case that combines the fiscal, Fed, trade, and immigration proposals; a “benign” scenario that includes only the fiscal proposals and an “adverse” scenario that includes more restrictive trade and immigration policies and a more hawkish Fed. The key assumptions for each scenario are listed in Exhibit 5.
Goldman simulates these three scenarios and lays out the results as follows:
- The “full” package boosts growth temporarily via the tax cuts (by about 0.2pp in 2017 H2 at an annualized rate) but then slows growth relative to the baseline thereafter (by 0.4-0.5pp in 2018-19). Core PCE inflation rises to 2.3% in late 2019 and the Fed delivers three additional rate hikes by the end of 2019.
- The “benign” package leads to a 0.4- 0.5pp boost to growth in 2017-2019, as the tax cuts provide a jolt to growth. Inflation is only marginally higher initially but then exceeds the target persistently starting in 2019 as the unemployment rate falls to 4%. The Fed hikes the funds rate 2-3 times more by the end of 2019 to lean against the overheating economy.
- The “adverse” policies lead to stagflation, with sharply lower growth and higher inflation. We find that real GDP growth is about 0.8pp lower in 2018-19 and the unemployment rate rises to 5.3%. Core inflation rises quickly, peaking at 2.3% in early 2019. The FOMC initially fights inflation with tighter policy but then stops hiking in 2019 in response to faltering growth.
While these theoretical scenarios paint a troubling picture for the US economy, with much growth "borrowed" from the future yet again in the best case, and an outright stagflationary recession in the worst case, Goldman's own expectations are slightly different. This is what Goldman's strategists expect will happen to the US economy under the Trump administration:
1. Fiscal proposals are likely to be enacted in scaled-down form. We expect that the three proposals noted above will become law, but in scaled-down versions of what has been proposed. Congress is likely in our view to enact tax legislation incorporating some aspects of the reform plans put forth by Mr. Trump and House Speaker Ryan. However, our preliminary view is that revenues might be reduced by around $100bn per year under a scaled-down plan rather than the $400bn per year under the Trump proposal, because we think there is a limit to how much deficit expansion will be tolerated. The focus among congressional Republicans has been as much on tax reform as on a tax cut; the Trump proposal is estimated to cost around twice as much as the House Republican tax reform plan, which itself was offered in the context of a broader House Republican budget proposal that aims to reduce the overall budget deficit by around 3% of GDP. With 52 seats in the Senate, legislation would need near-unanimous support from congressional Republicans to attain even the simple majority that would be required if tax reform were considered through the “reconciliation” process, which allows passage of certain fiscal legislation in the House and Senate with a simple majority. We expect that the marginal Republican senators will have qualms about significantly expanding deficits given the elevated level of federal debt.
We also believe there is a good chance that additional infrastructure funding will be enacted. It is not yet clear, in our view, whether this will be a tax credit-based plan, as Mr. Trump’s advisors have laid out, or a more traditional spending program. For now, we assume that an infrastructure program will be enacted that results in an additional $40bn annual investment. We expect that federal “discretionary” spending will increase slightly, by $10bn. Within this modest net increase we would expect two larger gross changes: we expect the “sequestration” cuts on defense spending to be largely undone, which could boost spending by $40bn per year, but we also would expect most of this to be offset with reductions in domestic spending, for a small net spending increase. All of these assumptions are likely to change as the discussions progress over coming weeks and months.
2. A slight hawkish shift at the Fed? We are unsure whether and to what extent Mr. Trump would favor a more hawkish Fed stance after taking office. That said, a slight hawkish shift seems most likely and we incorporate this into our central scenario.
3. The pace of immigration looks likely to slow. We are sceptical that much of his immigration plan will be implemented, as most of it would require Congressional approval and finding 60 votes in the Senate for these policies is likely to be difficult. However, the president has more discretion over immigration than many other policy areas, and we expect that the pace of immigration will slow somewhat under the Trump Administration.
4. Trade restrictions would increase, but not by nearly as much as discussed. We are very unsure about how much the Trump Administration will restrict free trade. While we assume that there is a low probability of reaching the top end of the range of the threatened tariffs, we expect that the average tariff applied on US imports is likely to rise. Our expectation is that the new administration might pursue one-third of what Mr. Trump has discussed on the campaign trail; considered as an equivalent average tariff-rate, this would result in a 4pp increase in tariffs on US imports, or roughly the average tariff rate during the Reagan Administration.
Exhibit 8 shows simulations of the economic implications of our central expectation of President-elect Trump’s policies. Annualized growth is 0.1pp higher than in the baseline in 2017H2 due to the tax cuts but then slows as the growth-adverse aspects of the policy package start to dominate. We find that GDP growth is 0.1- 0.2pp slower in 2018 and beyond. Core inflation is a bit less than 0.1pp higher than in the baseline and the FOMC delivers one additional hike by the end of 2019.
Of course, none of this is likely to happen as Goldman itself admits: "It is important to note that our analysis is subject to considerable uncertainty. Most significantly, our simulations rely on strong assumptions for which of the proposed policies might be adopted and how they are best captured in FRB/US. Moreover, FRB/US is a highly stylized description of reality that does not consider certain conditions that might matter for the economic outlook in practice, including policy uncertainty, changes to regulatory policies, and the global repercussions from Mr. Trump’s policies."
Because if there is one thing that computers are absolutely incapable of modeling, it is Trump, and certainly his economic policies.
Finally, Goldman's conclusions:
First, Mr. Trump’s policies could boost growth in 2017 and 2018, but are likely to weigh on growth thereafter if trade and immigration restrictions are enacted, or if Fed policy turns more restrictive. Second, core inflation and the funds rate are likely to be higher for the next few years in almost all scenarios—which makes the recent reaction of nominal interest rates to the election result look logical. Third, the risks around our base case appear asymmetric. A larger fiscal package could boost growth moderately more in the near term, but a more adverse policy mix would likely lead to a significant slowdown, higher inflation and tighter policy in subsequent years.
We look forward to finding out which scenario will be the correct one.