The U.S. economy update: despite Donald Trump's vows to unleash the potential of the U.S. economy, his agenda is generating considerable uncertainty.
While a recession or a surge in inflation is unlikely in the short term, economists are warning that the risk of "mild stagflation" is on the rise. This term refers to an economic state characterized by sluggish or stagnant GDP growth alongside inflation rates exceeding 3%.
Paul Ashworth, a North American economist at Capital Economics, is one of the proponents of this concept. He explained to MarketWatch that "mild stagflation" is a fitting term to describe potential economic conditions in the near future.
The term "stagflation" originated during the tumultuous period in the U.S. economy from 1974 to 1982. During this nine-year span, the country experienced four annual GDP declines, and inflation peaked at 13.5% in 1980. No one on Wall Street anticipates a return to those chaotic times. Even Ashworth does not believe that "mild stagflation" is the most likely scenario for the U.S.
Capital Economics predicts that U.S. GDP growth will be slightly below 2% in 2025, with inflation hovering between 3% and 3.5%—numbers that are historically not considered alarming. Other forecasting agencies expect GDP growth this year to be just above 2%, with inflation slightly below 3%.
Economists and businesses are increasingly anxious about the uncertainty brought about by Trump's policies. The unpredictable threat of tariffs complicates investment decisions, as companies cannot finalize plans without clarity on supply chain costs. Ashworth noted, "It's evident that Trump is taking tariffs more seriously than during his first term."
If Trump significantly raises tariffs on a wide range of goods and maintains them for an extended period, it could also heighten inflation. However, given his tendency to use tariffs as a negotiating tool, this remains uncertain.
The current inflation situation is already troubling. According to the Fed's preferred inflation measure, the PCE, the year-on-year increase was 2.6% as of last December, but early signs indicate significant price increases at the start of the year. In short, inflation is drifting away from the Fed's 2% target.
On immigration, regardless of its merits, the crackdown may also weigh on the U.S. economy. The growth rate of the domestic labor force is at its slowest ever. A sharp decline in immigration could deplete the labor pool. Companies would then face higher labor costs or need to invest in labor-saving technologies, which could be more expensive due to tariffs. In either scenario, inflation could rise.
The impact on GDP could also be substantial. If job growth stagnates, there will be fewer new workers earning wages and spending. Notably, consumer spending accounts for 70% of economic activity. The recent surge in consumer spending has been partly driven by a significant influx of immigrants. These newcomers, regardless of their legal status, contribute to consumption and GDP.
Unsustainable Growth Rates
The U.S. economy has already been growing well above its sustainable level, with GDP growth at 2.5% in 2022 and 2.9% in 2023, and similar growth is expected for 2024, although final figures are yet to be released.
Uncertainties from Fiscal Policies
The uncertainties remaining largely revolve around Trump's spending and tax policies. Government spending has been one of the three pillars supporting the U.S. economy. Even if significant cuts to the federal budget are warranted, the impact would be another drag on the economy. Conversely, Trump plans to extend tax cuts from his first term and introduce new tax incentives. While this could support GDP, it might also exacerbate inflation if the economy accelerates.
All these variables suggest that the Federal Reserve may have already ended its interest rate cuts. Bill Adams, chief economist at Comerica, stated, "The Fed is also monitoring the impacts of higher tariffs, stricter immigration policies, and tax cuts. These policies could exacerbate inflation as their effects ripple through the economy, leading the Fed to maintain higher interest rates."
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