In our view, there are three areas of risk emanating from Washington: Fiscal policy, trade policy, and regulation and the business climate. In short, we know far less than we would like about the basic details of plans for implementing policy and regulation under the new political regime.

Questions of fiscal policy

With respect to spending, President Trump continues to support his infrastructure plans, and there is strong support among Congressional Republicans for relaxing the constraints on military spending. On the revenue side, there is broad support among Republicans for some form of personal tax cut. How large it will be and when it will become effective are still unclear, but we expect it to lift demand in the U.S. economy. It might be bigger and earlier in 2017; it might be smaller and later. It might be linked to limitations on deductions. Aside from these unknowns, the big questions concern how it fits into the administration’s other fiscal plans and how the overall growth in the deficit will be handled.

The incoming administration has indicated it likes the idea of an ad hoc approach to deals. This fact lends support to our skepticism about a genuine, growth-friendly tax reform package.

For the time being, we think it would be prudent to assume two things: first, that we will see only a small boost to household demand; second, that there are clearly inflation risks associated with a large fiscal impulse.

On the corporate tax front, there are some big numbers being thrown around and some large changes being considered. This is not only a question of corporate tax rates; it is also a matter of tax incidence. Tax experts have long wanted to lower tax rates but broaden tax incidence by sharply reducing the number of special breaks that are in the corporate tax code, and the issue of “border adjustability” has also come into play.

There is no doubt that the U.S. corporate tax code could be changed in a way that enormously enhances efficiency and might even increase total federal tax receipts. The question is how uniform the tax code can become in the face of the army of well-paid lobbyists and campaign contributors anxious to preserve their special deals. The incoming administration, to the extent it has sent any signals at all about this, has indicated it likes the idea of an ad hoc approach to deals. This fact lends support to our skepticism about a genuine, growth-friendly tax reform package.

What about the deficit?

If we take all of this at face value, the proposed tax cuts and infrastructure spending would lead to a large increase in the federal deficit, and would give a potentially big boost to nominal growth, with both real growth and inflation rising. However, although this growth impulse might last for a number of quarters, the Fed would have to respond to the changed inflation outlook. In addition, the mix of loose fiscal policy and tighter monetary policy would push the dollar higher, which would act as a brake on the economy.

But is such an outcome very likely? The Republican Party continues to be home to numerous fiscal hawks — one of whom has been appointed to lead the Office of Management and Budget. Indeed, Mick Mulvaney is a founder of the House Freedom Caucus and shut down the government to make a point about federal spending during President Obama’s term.

Within the Congressional Republican Party, the orthodoxy is that tax cuts can be paid for by cuts to entitlement spending. But Trump’s campaign promised no cuts to Social Security and Medicare, and polling evidence suggests Trump supporters are not free from anxiety about their incomes in retirement.

No one knows how this will play out. The Republican Party has many internal divisions — one of which has been on full display in the debate over Russia and cyber threats to the recent election. Perhaps Congress will resist the full range of fiscal measures that Trump advocates. We won’t have to wait too long to get some insight, however, as the debt ceiling debate is fast approaching. Our guess is that, overall, we will have a fiscal impulse this year, but that it won’t be very large.

Words and action on trade policy

It could be that Trump’s rhetoric on trade is just posturing to negotiate better deals, and probably will just be swept under the carpet. We are skeptical about this — primarily because of Trump’s nominees to a range of executive posts.

Peter Navarro, an avowed protectionist, has been appointed to the new role of “Director of Trade and Industrial Policy” and as head of the newly created “National Trade Council.” Robert Lighthizer, a lawyer with much experience seeking protection for the U.S. steel industry, has been tapped to head the U.S. Trade Representative office. And Trump himself has revealed his protectionist proclivities — witness his comments to major auto manufacturers regarding the balance of their North American production. Against this backdrop of tariff threats, we think it would be sensible to prepare for some early measures directed at China as well, and we note that the Office of the President of the United States has considerable authority to act on trade and tariffs without Congressional approval.

Again, however, we must point out that there are divisions within the Republican Party on trade — even within the group of close advisors who will be in the White House. Gary Cohn, for example, the Goldman Sachs executive whom Trump tapped to lead the National Economic Council, is an avowed advocate of free trade and is not likely to be quiet in internal debates on trade policy. But just as we think there is a risk of more fiscal stimulus than the fiscal hawks would like, we think there is a risk of more trade protection than the free traders will appreciate.

Rising, not falling, regulation risks

One might think that if there is one thing all Republicans could agree on, it would be that reducing red tape, clarifying and simplifying business regulation, and setting out clear and fair rules for business are good. Curiously, however, this is not necessarily the case in practice, at least when it comes to health care.

Congress has taken steps to “repeal” the ACA, but it appears likely that not all of it will be repealed, and there is no apparent consensus on which parts should be repealed.

It is quite remarkable that, some six years after the introduction of the Affordable Care Act (ACA), the Republican Party has been unable to reach an internal consensus on what should replace it. Congress has taken steps to “repeal” the ACA, but it appears likely that not all of it will be repealed, and there is no apparent consensus on which parts should be repealed. The supposed “replacement” of the ACA, moreover, has not been described in sufficient or consistent detail.

The economic impact of change could be significant. Health-care expenditure is about 18% of GDP, which, as a share of GDP, is about the same as the gross output of the entire manufacturing sector. Finance is also another huge sector of the economy and, again, there’s a lot of talk about Dodd–Frank but no clarity about exactly what the new legislative regime will be.

Currently, one area we are focusing on is corporate investment, and we are formulating a carefully analyzed view on the possibility of an upturn in capital expenditure. We hope to have more to say on this in the next month or so. But, in the meantime, we would caution that regulatory uncertainty has risen so far this year, not fallen. Consequently, on balance we are inclined to think that the growth boost from the new administration will be modest, and will be more likely to add to inflation than to real growth prospects.


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