Itaú BBA - Trumponomics

Macro Vision

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noviembre 18, 2016

Fiscal expansion will lead to tighter monetary policy by the Fed

Based on campaign promises, the agenda of President-elect Donald Trump stands on three economic policy pillars. The first one is an expansive fiscal policy based on tax cuts. The second one is trade and migration protectionism. The third is deregulation for several industries.

Campaign promises may be watered down by Congress. In the fiscal front, a lot can be approved by a simple majority and Republicans held on to the majority in both chambers. However, fiscal room is limited and, hence, Republicans should be less aggressive regarding tax cuts than in the Ronald Reagan and George W. Bush administrations. The commander-in-chief can renegotiate free trade agreements (such as NAFTA) and hike import tariffs without Congressional approval, but a more aggressive trade policy is likely to prompt retaliation by trading partners, thus reducing the benefits of higher import tariffs. Regulatory overhauls generally require approval by 3/5 of the Senate, and thus require support from Democrats.

Hence, we anticipate moderate fiscal expansion and modest protectionist measures. The net effect will be a boost to short-term GDP growth, but without significant consequences in terms of potential GDP growth.  We estimate an initial boost to aggregate demand representing 0.8 p.p. of GDP.

However, the U.S. economy is close to full employment (unemployment rate: 4.9%) and to the inflation target of 2% (core PCE deflator: 1.7%).

Thus, the Federal Reserve will have to tighten monetary policy to offset the fiscal stimulus. We forecast the Fed will raise its Fed Funds rates by 175bps until the end of 2018, 50bps more than in our previous scenario, and 70bps more than currently implied by the markets.

We revised upward our 2018 forecasts for GDP growth by 50bps to 2.4% and for inflation by 10bps to 2.1%, assuming that fiscal measures will be approved by mid-2017, with its effects peaking in 2018, assuming the Fed partially offsetting the fiscal impulse with tighter monetary policy.

We outlined below the proposals presented by Donald Trump during the campaign and the expected outcome after the legislative approval process. In the coming weeks, Trump will choose his cabinet and we will then have more clarity about the path for these policies.


Fiscal policy

Tax reform: Goal is to simplify and reduce the tax burden

The goal is to reduce the corporate tax rate to 15% from 35%. The measure is estimated to increase the federal deficit by US$ 160 billion per year (0.9% of GDP).

The number of individual tax rates is supposed to drop to 3 from 7. Furthermore, he also proposed a decline in the medium and maximum tax rates (to 33% from 39.6%).

If both measures are fully adopted, the federal deficit would increase by US$410 billion per year, or 2.2% of GDP.

There are other, less significant tax measures, such as reducing the number of tax deductible items. Trump also wants to adopt a tax holiday to encourage companies to bring home profits stashed overseas. The plan is based on a much lower temporary tax rate of 10% (vs. 35% currently). According to some estimates, U.S. companies have US$2.5 trillion stashed abroad.

  Expenses: investment and military spending

During the campaign, Trump promised to encourage capital and defense spending in the short term. These stimuli may represent US$100 billion per year, or 0.55% of GDP.

Investment may be encouraged by spending, concessions and tax incentives to the private sector. In that sense, the creation of an economic development bank is under consideration.

In the medium run, the goal is to increase government efficiency, reducing discretionary spending by 1% per year over 10 years. The proposal includes a hiring freeze in the federal government.

Approval by Congress and outlook 

Budget measures may be approved by a simple majority in both chambers, as long as the federal deficit is not planned to be greater within 10 years than in the previous law.

The Republican majority in Congress will likely enable the approval of a moderate fiscal deficit that is smaller than Trump planned, thus avoiding sharp deterioration in the federal government’s finances.


Protectionist policies 

  Trade: Protect the domestic industry against unfair foreign competition

Trump promised to renegotiate relations with key trading partners. Some of the possible measures mentioned during the campaign were revoking free trade with Canada and Mexico (NAFTA) and imposing a 35% tariff on Mexican goods; labeling China a currency manipulator[1] and hiking the import tariff to 45%; interrupting negotiations for the Trans-Pacific Partnership (TPP); pulling out of the World Trade Organization and renegotiating trade relations with 162 countries that joined the WTO.

Approval by Congress and outlook 

The President does not need congressional approval to end NAFTA. All it takes is to notify the partners (Canada and Mexico) six months in advance. He can also use current WTO provisions to hike import tariffs on an industry by industry basis to offset dumping practices.

Despite having legal authority on trade, the campaign proposals are likely to be watered down. An aggressive stance, unilaterally raising import tariffs, should prompt retaliation by its trading partners. And a tariff war would be harmful to all involved.

The interruption of TPP negotiations is all but a certainty, as it just depends on Trump’s will and has no big consequences because it is not in effect yet. We also anticipate renegotiation of some terms that rule NAFTA and believe that China will be labeled a currency manipulator, leading to modest increases in import tariffs for some specific industries. Furthermore, Trump will probably hike tariffs for some industries, using the WTO’s antidumping mechanisms more often.

  Immigration policy: Less violence, more jobs for U.S. citizens

Donald Trump promised to enforce immigration laws, deport millions of undocumented immigrants, increase resources for border security and build a wall on the border with Mexico.

Approval by Congress and outlook 

Non-budget legislation changes require approval by a qualified majority of 3/5 of the Senate. Funding for border security and/or for the construction of a wall on the border with Mexico may be approved by a simple majority.

He will likely get approval for funds to reinforce border security and to deport undocumented immigrants with a criminal record. He is unlikely to get approval for a new law to deport millions of undocumented immigrants, as he would need support from Democrats in the Senate. 



  Healthcare: Affordable Care Act (“Obamacare”)

His goal is to partially or fully repeal the Affordable Care Act, which gave health insurance subsidies to low income individuals.

  Banking: Dodd-Frank Act

His goal is to amend or reject the financial system reform, reducing borrowing costs for the real economy. His proposal was not detailed, but the partial (or full reversal) of many items in this law is possible:

a)     Abolish the Consumer Financial Protection Bureau (CFPB), created to prevent abuse by banks in consumer loans, particularly mortgages.

b)     Abolish the Financial Stability Oversight Council (FSOC), which determines the systemically-important banks that are subject to greater capital requirements.

c)     Reject or ease the Volcker Rule, which limits speculative positions by banks in their proprietary portfolios.

  Energy: Clean Energy Act

His intention is to deregulate the energy industry by rejecting the Clean Energy Act, which allows the government (namely the Environmental Protection Agency) to regulate carbon emissions; approving funds to build the Keystone oil and gas pipeline system from Canada and the Midwest to ports in the south; and renegotiating the nuclear deal with Iran.

Approval by Congress and outlook 

Most regulatory reforms require non-budget legislative changes and, thus, require approval by a qualified majority of 3/5 of the Senate.

It is possible and likely that Obamacare will be partially rejected by a simple majority, as it includes items that depend on public financing and, thus, may be revoked by a budget reconciliation act.

Approval of funds to build the Keystone Pipeline may also be approved by a simple majority and there is high probability that it will be sent to Congress in the first half of 2017.


Roberto Almeida Prado

[1] Currency manipulator.The law requires the Secretary of Treasury to monitor anti-competition practices. A country that has (i) large bilateral trade surplus with the U.S., (ii) large current account surplus, (iii) persistent interventions in the FX market should be labeled a currency manipulator. The Treasury should notify and renegotiate changes in behavior with the country labeled as such. If the behavior does not change, the Treasury may: (i) forbid financing via U.S. government’s development financing institutions; (ii) forbid government purchases, (iii) IMF heads supervision, (iv) verify the need to renegotiate bilateral/regional treaties.



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