Donald Trump made a specific pledge on inflation many times during his presidential re-election campaign. On September 25, for example, he said: “Starting on day one, we will end inflation and make America affordable again.” Well, day one has passed, what has he done?
Not that much. In his inaugural address, the president pledged to “direct all members of my cabinet to direct the best powers at their disposal to defeat what was record inflation and bring down costs and prices”. He declared a national energy emergency, adding that the new administration would “drill, baby, drill” in a bid to bring down energy prices. Oil prices fell by a little over $1 a barrel on the announcement but are still about $5 a barrel higher than at the end of December. And without announcing new tariffs, he said that in an overhaul of the trade system, “we will tariff and tax foreign countries to enrich our citizens”. Later, he threatened specific tariffs on Canada, Mexico and others in answers to reporters’ questions at the end of the day.
So, it was mostly more promises, rather than action on day one. The purpose of this article is not to examine what he has done, but to look at what people believe he will do. What I want to examine is people’s inflation expectations under Trump. These are shown in the chart below both for the year ahead and five years ahead, split by party affiliation and collected by the University of Michigan.
Republican voters were pessimistic about inflation during Joe Biden’s presidency and suddenly expect Trump to succeed in stopping inflation over the year ahead while bringing annual price rises below 2 per cent over the next five years. The reverse applies to Democrat voters.
Looking at charts such as this, it’s easy to throw up your hands and say it is all hopeless. Respondents are simply expressing their political preference through a consumer survey and the results should be discarded in a highly partisan and divided US.
Easy and wrong, said Joanne Hsu, director of the surveys of consumers at the University of Michigan. She told me that respondents were reacting to probable policy changes on tariffs. “It is a difference in what people are thinking Trump’s policies will bring to the economy. These are legitimate,” she said, adding that they were corroborated by an increase of numbers among Democrats thinking it was a good time to buy cars and consumer durables before tariffs applied. “People are expressing their views in the survey and acting on them with their wallets,” Hsu said.
There has been a bump higher in US auto sales in recent months, for example.
If we accept that respondents are not just using these surveys as an expression of political vibes, that does not mean they are showing clear thinking.
In fact, people generally get the link between Trump’s policies and inflation wrong.
Republicans are far too optimistic. There is nothing in his actions or in current US inflation momentum that suggests prices will stop rising in the year ahead. Republicans will need to accept his excuses over the coming months. Over the next five years, however, Republican voters’ expectations of just under 2 per cent inflation are reasonable.
Democrats are also wrong. They are worrying too much about tariffs and tax cuts being inflationary.
As far as tariffs are concerned, they raise prices, but they do so for specific imported consumer and intermediate goods, which are small in the US and much smaller than other countries. So, we should be careful not to exaggerate the inflationary effect.
The chart above shows goods imports and exports and the remarkably closed nature of the US economy. Bureau of Economic Affairs data shows goods imports to be worth 11 per cent of US GDP in 2023. So, in an extreme scenario that these imports became 10 per cent more expensive, including imports of oil, but the same quantity was purchased and nominal consumption and investment rose to pay for them, it would add just over 1 percentage point to the price level and hence inflation for one year.
This is not the inflationary world Democrats are expecting and my assumptions were ridiculously extreme (for example, expecting tariffs to be applied to oil imports) to make the point that tariffs are not that inflationary.
The second area where Trump’s policies might stoke inflation is the budget deficit. His plans to lower taxes are large and specific, while his ambitions on curbing public spending are vague. As the chart below shows, the US federal government has not tried hard to lower deficits since the mid-2010s and, even excluding the Covid-19 period, the trajectory shows deficits continuing to deteriorate.
Higher deficits can create excess demand and inflation. But how large? Prominent Democrat-supporting economists have disagreed on their importance in the past few days.
Speaking to Martin Wolf last month, Larry Summers of Harvard University and former US Treasury secretary, was alarmist. “If the [Trump] programme were implemented as described in the campaign, I am very confident that the inflationary impulse would be significantly larger than the impulse represented by the Biden programme that was put in place in 2021,” he said.
In contrast Jason Furman, also of Harvard, was more reassuring. “Trump’s policies likely inflationary. But worth setting expectations: plausibly add a few tenths,” he posted on X.
These two predictions are not as far apart as they first seem. Summers is talking about the inflationary impulse that Trump’s policies might bring. Furman is talking about outcomes.
The step missing is Federal Reserve policy. The key reason we should expect Democrat households to be wrong about their inflation expectations is that the Fed will not let another bout of rapid price rises happen. It will impose tighter monetary policy than otherwise in the face of Trump’s policies.
Its actions this year have been fascinating and reinforce the point. In areas peripheral to its core mission, Fed governors have bent over backwards to fall in line with the new political landscape. They voted to withdraw from the global central bank Network for Greening the Financial System (NGFS), saying it was “increasingly” working outside the Fed Board’s mandate. Michael Barr, the Fed’s vice-chair for supervision, stood down from this position overseeing financial regulation to avoid the “risk of a dispute” with the incoming administration, but pointedly did not resign from the board.
The strategy is clear. Hug the statutory dual mandate of price stability and maximum employment tight, while bend with the wind in less important areas.
Ultimately, then, it is the Fed that should prevent inflation rising as Democrats expect, if it does its job properly. Many Democrats have missed this part of the process.
Austan Goolsbee, president of the Chicago Fed, put the Fed’s general attitude well last week, saying that the way to deal with Trump’s economic policies was similar to dealing with Mid West weather. “There is no bad weather, there is only bad clothing,” he said. “You tell me the conditions and I’ll tell you what jacket to put on.”
In short, the Fed will react to the conditions imposed by Trump. You should not expect this to be highly inflationary, but monetary policy might be significantly tighter.
What I’ve been reading and watching
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Germany’s economy did not suffer the predicted massive recession after Russia’s invasion of Ukraine, but it is hopelessly stagnant
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The Bank of Japan has sought to avoid the market turmoil of its last rate rise by giving some very heavy hints that it will act later this week. Rates are set to rise a quarter-point to 0.5 per cent
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Martin Wolf is worried about real interest rate rises in the UK. He says the era of cheap borrowing is over and policy needs to respond
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Duncan Weldon says much of the reasoning underpinning a strong dollar might be wishful thinking
A chart that matters
Alan Taylor gave his first speech as a Monetary Policy Committee member at the Bank of England last week, which included a chart from this newsletter. Because you’ve seen that chart on trends in UK inflation metrics before, the more interesting one was his very transparent schema for which UK interest rate paths are consistent with different versions of the UK outlook.
The BoE has three cases it is considering regarding the persistence of inflation. The MPC says it thinks case two, which requires some additional unemployment to eradicate inflation, is the central case. This, Taylor said, would bring four interest rate cuts this year, followed by another four in 2026 until a terminal rate around 2.75 per cent is reached.
His view was that there was an increasing risk the UK would fall into recession and inflation would drop away faster. This was his downside scenario. I’ve added current financial market rates to the dotted schemas he published (see chart below).
It shows that financial markets are expecting much more inflation persistence and the BoE to act much more cautiously. That is logical if market participants think the BoE has it wrong on inflation.
But it is not obvious to me that financial markets disbelieve the BoE’s view of the central path for the economy. City forecasters expect inflation to fall back to target within two years. If so, there appears to be some dislocation between what markets and MPC members believe are interest rates consistent with stable inflation. And that is ultimately a battle the BoE will win because the MPC sets short-term interest rates.
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