At the start of the year markets were expecting Congress to make progress on a package of growth-boosting measures around tax reform and infrastructure spending. At the same time, there were concerns about increasing US protectionism with the pledge to abandon the Trans Pacific Partnership trade deal and desire to renegotiate NAFTA both seen as a shift towards a more protectionist US. This policy mix led market-based measures of inflation expectations to rise following the election.
It’s now mid-year and the timetable for key legislative priorities has slipped. The Republicans, who campaigned on repealing Obamacare, decided to tackle this first, but have not been able to agree on how to reform the Affordable Care Act. This has contributed to delays around tax legislation.
Equally, there is internal conflict over the details of tax policy changes within the Trump administration and Republicans. Throw in the legal cloud surrounding President Trump, and the battle around the budget resolution and debt ceiling, and it is not surprising that the market has lost confidence in the reflation trade.
But at least the US administration has not adopted the feared approach to global trade. In addition, rolling back some of the regulatory pressure on business appears to be underway. Several energy projects are now likely to go ahead and while it is not clear exactly what will happen to Dodd-Frank, financial regulation is set to become less onerous. This has helped maintain high levels of business and consumer confidence, although this does not appear to have had much impact on current activity.
Still, the pressure is building for the Republicans to deliver ahead of the midterm elections, and there are signs of movement in key areas. Healthcare appears to be inching towards resolution. This does not necessarily mean there will be new legislation, but that Republicans will at least decide to move on, one way or another.
Pressure is building for the Republicans to deliver
There also appears to be growing recognition that tax reform is just too complicated. The controversial border adjustment tax (BAT), which is a critical revenue raising element to pay for the ambitious corporate tax rate favoured by the leadership, lacks support from most Senate Republicans. This suggests the focus might shift more towards pure tax cuts than reform. It also means the deficit is likely to rise in coming years, though there are a number of accounting tricks which are likely to be deployed to enable Congress to claim it is revenue neutral.
The most egregious is the potential aggressive use of dynamic scoring. This will assume that the tax cuts boost growth which in turn generates revenues to help pay for the measures!
Away from the all the political noise and despite fluctuations in quarterly GDP, the US has continued to grow moderately, but still above trend. Unemployment fell to 4.3 per cent in May, a historically low level. Wages and inflation have remained lower than expected which has allowed the Fed to move slowly on interest rates. This, in turn, has created benign financial conditions, allowing the expansion to continue. In many ways, the failure to adopt a fiscal stimulus is helping to extend the economic cycle.
Yet if Congress finally delivers in 2018, the timing will be poor, coming when the US is already at full employment. A boost to aggregate demand could put upward pressure on wages and inflation and force the Fed to raise rates faster than expected. This could then expose the heavily indebted corporate sector and liquidity-fuelled asset prices. While tax cuts might protect some seats for the 2018 midterms, the economy could be suffering the aftermath of a recession in the next round of elections in 2020.
Tim Drayson is head of economics at LGIM