WEEK AHEAD

"We know now that inflation results from all that deficit spending. Government has only two ways of getting money other than raising taxes. It can go into the money market and borrow, competing with its own citizens and driving up interest rates, which it has done, or it can print money, and it's done that. Both methods are inflationary. "

– President Ronald Reagan, Address to the Nation on the Economy, February 1981

Much Ado About Nothing: Tariffs, Deficits & Fed Risks 

During President Trump's brief time in office, he has made many policy changes, stimulating debates and speculation. However, thus far, none of the changes implemented by the new President address the most formidable threats to economic stability in the US: large and persistent deficits and counter-productive Fed policies.

President Trump's earliest economic policy initiatives have included numerous adjustments in tariffs and an initiative directed at identifying wasteful spending. Simultaneously, the President has stated he wants to reduce regulations, eliminate taxes on certain forms of income, and maintain the current tax schedule, which was put in place during his first administration but is due to sunset in 2025.

The tariff initiatives have stirred unrest in the markets. Tariffs are tax increases and are likely to reduce economic growth, all other things being equal. However, based on observations of past behavior with President Trump, other things are rarely equal. The President threatened to raise tariffs on imports from Canada and Mexico if they did not help increase security along US borders.  Both countries offered their help to achieve the desired level of security, and the President put in abeyance the tariff increases. The President has raised, or threatened to raise, tariffs on imports from China and other countries, but it is difficult to ascertain his motives for doing so now. He appears to favor growth-stifling protectionist tariff policies on the one hand but pro-growth tax and regulatory policies on the other.

While the tariff drama played out, the President established the Department of Government Efficiency (DOGE) and empowered Elon Musk to uncover waste, fraud, and abuse within government agencies. Thus far, Mr. Musk, through an examination of spending policies within agencies and departments, has uncovered numerous newsworthy instances of either egregious mismanagement of funds or outright fraud. While "waste, fraud, and abuse" is a standard mantra for those seeking to reduce Government spending and close budget deficits, the net amount of any savings is likely far less than the almost $2 trillion needed to close the budget deficit.    

Rising tariffs and the results of the DOGE investigations have seized the public debate, but the truly major threats to economic stability remain unaddressed. The CBO estimates the budget deficit for 2025 to be about $1.9 trillion. The Fed is reducing liquidity while employment growth is at about a 1.3% annual rate. 

Market participants seem to hang on to every word Fed Chairman Powell utters, listening for hints about the Fed's short-term interest rate policies. The market wants lower rates, and Mr. Powell wants to lower inflation to 2%.   The common belief is that lower rates mean greater liquidity and greater liquidity is consistent with rising economic growth. Unfortunately, Mr. Powell believes the correct policy for reducing inflation is to lower real growth, and higher interest rates are consistent with that goal.

The latest reading on inflation is above the Fed's target, 2.9% versus 2.0%. In view of this reading, Mr. Powell has stated that there is no need to rush to lower rates. Mr. Powell's chosen policies are inconsistent with his goals, and his goals and policies are poorly chosen. There is no reliable relationship between interest rate changes and liquidity changes. For example, during the Great Depression, Fed Funds rates remained near zero, but the money supply declined by one-third.  More recently, as the Fed lowered interest rates, the rate of growth of the Monetary Base, a measure of liquidity, turned negative on a year-over-year basis.  Declining liquidity will produce eventually a decline in real economic growth. The Fed should target liquidity or prices, not interest rates.

The Fed's targeted inflation rate of 2% annually is well below the long-term average of about 3.25%. If the Fed continues to try to drive inflation down to its target by manipulating interest rates, it is likely that economic growth will decline as liquidity declines. 

The latest data show job growth at about 1.3% at an annual rate. This rate of growth is not consistent with robust economic growth. As the Fed chases its goals, it will provoke criticism from President Trump and his team of economic advisors. The Fed will ignore the evidence generated over the last fifty years and argue that slow economic growth is needed to reduce inflation.  During the 1970s, real economic growth declined while inflation increased, and during the 1980s, real growth increased and inflation declined.  The President's advisors are aware of these data, and conflicts between the Fed's policy team and the President and his team are inevitable.  Markets will not fare well as these conflicts escalate.

The largest threat to economic stability is the $1.9 trillion budget deficit. And no one in either party has brought forward any plans to reduce that deficit significantly. The absence of interest in reducing the deficit reflects an unwillingness to address costs associated with the Social Security and Medicare programs, which are the biggest drivers of the deficit.

 The CBO forecasts budget deficits of about $2 trillion annually will persist for the next ten years. If the forecast is accurate, outstanding debt will grow to about 125 % of GDP, a level not reached since WWII. Currently, interest payments on the debt are about 3.4% of GDP, about the same percentage as total defense spending.  The CBO forecasts interest payments will rise to over 4.0 % of GDP by 2035, which will grow to more than 18% of Federal Government tax receipts. These trends are not sustainable.  Interest payments will crowd out other expenditures and provoke uncomfortable choices.

The large deficits will force the Fed to confront a choice of monetizing the debt, increasing liquidity, and increasing the probability that inflation will rise or persist in its efforts to lower inflation to 2.0%. If inflation increases, the Trump Administration will be blamed for rising prices, just like the Biden Administration.  President Trump and his team will try to shift the blame to the Fed, and an open conflict will develop between the Fed and the administration.