Warning of inflation risks after US presidential election

The Federal Reserve's two-and-a-half-year-long battle against inflation appears closer than ever to victory. But the November 5, 2024 presidential election could take the story in a different direction...

Inflation in the US has fallen to a level close to the Fed's 2% target, as the central bank has raised interest rates aggressively since March 2022. Inflation has also eased as supply chain bottlenecks during the Covid-19 pandemic have been eased and the economy's workforce has improved. However, whether inflation will continue to decline next year will largely depend on the policy choices of the next occupant of the White House.

In the final stages of the election campaign, both former President Donald Trump, the Republican candidate, and Vice President Kamala Harris, the Democratic candidate, have proposed policies that promote growth but are likely to slow the process of reducing inflation. Analysts say that Mr. Trump's policies could cause inflation to rise more strongly. When it comes to inflation, Trump’s policies have included imposing tariffs on all imports, deporting illegal immigrants, and pressuring the Fed to lower interest rates. “These policies have been more inflationary in aggregate. I have a legitimate concern that inflation will be worse in 2025,” Brian Riedl, a former Senate Republican aide who now works at the Manhattan Institute, a conservative think tank, told the Wall Street Journal.

In addition, if Trump is re-elected, his second term will take place in a much different economic environment than his first. Before Trump’s first four years in office, inflationary pressures in the US had been low and stable for many years. But recently, US Treasury yields have risen sharply on expectations that Mr. Trump will win the election and that his new term will lead to higher budget deficits, or higher inflation, or both.

THE US ECONOMIC BACKGROUND

Given the changed economic environment and the potentially far-reaching policies that Mr. Trump has proposed, there is every reason to worry that the threat of inflation will be greater if Mr. Trump is re-elected, according to Marc Short, who served as White House legal counsel during Mr. Trump’s first term. Mr. Trump’s policy proposals this time could also draw him into a new confrontation with the Fed, the agency with the mission of keeping inflation low.

Inflation in the US is largely driven by global factors rather than by the policies of each president. During Trump’s previous term, the lingering effects of the 2008 global financial crisis weighed on demand and price pressures globally. Inflation in the US picked up shortly after President Joe Biden took office, as the US economy reopened after the Covid-19 pandemic lockdown.

The strong demand rebound as the economy reopened was further boosted by the Biden administration’s ultra-low interest rate environment and massive stimulus package. The inflationary effect of this combination was further amplified by supply chain bottlenecks and a tightening labour market. In the summer of 2022, after the Russia-Ukraine war broke out and sent energy prices soaring, annual inflation in the United States hit 9.1%, the highest since 1981.

Inflation then eased as supply-chain bottlenecks unraveled and the Fed raised interest rates to their highest level in more than two decades. In September 2024, the year-over-year increase in the US consumer price index slowed to 2.4%, close to pre-pandemic levels. Going forward, global trends will likely continue to be the main driver of US inflation, but the US president’s policies could exacerbate or weaken those external forces.

Ms. Harris has pledged to address the cost-of-living crisis by boosting home construction, combating price manipulation, and expanding the child tax credit. She plans to fund the new spending through tax increases, but has not yet laid out a concrete plan for sharply reducing the government deficit. “If the Democrats retain power, I don’t think inflation will spike, but it will be somewhat persistent and stubborn,” Riedl said.

For his part, Mr. Trump wants to extend the 2017 tax cuts that are set to expire after 2025, and lower the corporate income tax rate. He also proposes eliminating taxes on service-sector tips, overtime pay and Social Security benefits for retirees. But changes to trade and immigration policy — areas where he has the power to act without congressional approval — make Mr. Trump more unpredictable when it comes to inflation. “If Mr. Trump does what he says he will do, the U.S. economy could suffer a negative supply shock. Prices would rise, and the economy’s ability to supply goods and services would decline,” said Adam Posen, president of the Peterson Institute for International Economics.

THE RISKS OF TRUMP’S IMMIGRATION POLICY

A study by the Peterson Institute estimates that deporting illegal immigrants would cause a sharp decline in US economic output and a rise in inflation. With fewer workers, businesses would have to raise wages and prices for goods and services, or accept lower profits.

Supporters of Trump’s immigration policy say the US economy would be better off if Americans were paid more for the jobs that immigrants are doing. “If we restrict the job market to give Americans jobs, they will get paid more, and prices will go up. To me, that’s how the market works,” Oren Cass, founder of American Compass, a think tank that supports Trump’s trade and immigration policies, told the Wall Street Journal.

But many economists say the labor market is more complicated than that, and warn of knock-on effects from a shrinking workforce. Economists at the University of Colorado, Denver, studied deportations of illegal immigrants under the Bush and Obama administrations from 2008 to 2014. They found that for every 1 million illegal immigrants deported from the U.S., 88,000 American workers lost their jobs.

That’s because immigrant workers in certain industries, such as food processing, agriculture, construction, and hospitality, are not necessarily competitive with American workers. If those workers are deported, instead of hiring more native-born workers, those businesses may scale back operations. The resulting drop in sales would leave fewer high-paying jobs for native-born workers in those industries.

Business leaders and economists also agree that the cost of tariffs will be borne by American consumers. “We’re going to have to pass the cost of tariffs onto consumers,” said Philip Daniele, CEO of AutoZone.

Mr. Trump has proposed a 10% tariff on all imports and a 60% or higher tariff on Chinese goods. Mr. Trump’s advisers say his tariff plan would not be inflationary, partly because the tariffs imposed in 2018 and 2019 were not inflationary, and partly because they believe Mr. Trump is using the threat of tariffs primarily to gain leverage in negotiations.

THE INFLATIONAL EFFECT OF TARIFFS

“Just like in 2016, Wall Street and experts predicted that Trump’s policies would slow growth and increase inflation… In fact, growth and job creation have far exceeded those projections,” said Brian Hughes, a senior adviser to the Trump campaign.

Some conservative economists also say that Trump’s promise to deregulate, especially in the energy sector, could help reduce inflation by removing obstacles to energy production.

But Mr. Short, Mr. Trump’s former legislative adviser, said that in his first term, Mr. Trump did not cut spending as he promised. That means investors are underestimating the risk that Mr. Trump will be less business-friendly in a second term. “Trump’s first term saw a significant loosening of regulations, but I’m not sure that will happen again in a second term, because most people around him now see a much broader role for government in the economy,” Short said.

For the Fed, determining the downstream effects of higher tariffs will be a complicated and uncomfortable task. Anything that stokes inflation could prompt Fed policymakers to slow or even pause rate cuts. The Fed cut rates for the first time in more than four years at its September 2024 meeting.

Trump has repeatedly pressed the Fed to lower rates in his previous term. If he wins the next term, he will likely appoint a new Fed chair in 2026. Short predicted that Trump would be “a president who is very active in engaging with the Fed.”

Fed officials may conclude that tariffs are like a tax hike that weakens demand. In 2019, tariff hikes roiled global financial markets and threatened to dampen business investment. The Fed cut rates after concluding that the negative impact of tariffs on economic growth would outweigh any inflationary effects they might have.

TRUMP-FED CONFLICT RISKS

Some experts say the Fed may be neutral this time. At a conference this summer, Fed Governor Christopher Waller, a Trump appointee, suggested that if tariffs cause a one-time price increase, “it’s probably just the last supply shock that a central bank needs to consider.”

But others worry that tariffs could fuel inflation. For example, workers could demand higher wages because of rising prices. America’s trading partners could retaliate with tariffs on American goods, sparking a tit-for-tat trade war. “That seems to me to be more inflationary than a one-time change in prices,” said Austan Goolsbee, president of the Chicago Fed.

In addition, the Fed is unlikely to sit idly by as prices rise, as officials misjudged the start of inflation in 2021, with the view that it was “transient.” As price pressures spread across the economy, the Fed had to raise interest rates aggressively to ensure that businesses and workers did not expect higher prices to become the new normal. “There is nothing wrong with worrying that if a second wave of inflation follows a previous one, the second wave of inflation will be much more severe,” Posen said.

The rising federal budget deficit is another concern. Some analysts worry that the growing list of spending and tax cuts promised by both candidates will lead to a rise in the deficit, as politicians tend to understate the full cost of their plans. Economists say the United States would be better off with a lower budget deficit and the Fed able to cut interest rates further.

Analysts predict that both Trump and Harris's spending plans would add to the federal debt, but Trump's would require Washington to borrow more than Harris's. Experts estimate that Harris's plan could add $3.5 trillion to the U.S. budget deficit over the next decade, while Trump's could lead to a $7.5 trillion deficit over the same period.

If Trump wins, the combination of a higher budget deficit combined with the inflationary effects of his immigration and tariffs could trigger a chain reaction in the bond market, where investors would demand higher yields to hold U.S. Treasuries.