Since Donald Trump’s election, breakeven inflation rates (BEI)1 have risen in both spot and forward terms, and markets more broadly are discounting the possibility that the Trump administration will be transformative for the US growth and inflation outlook. We remain skeptical that the administration’s policies will jolt the US economy out of low trend growth and secular stagnation. But we are much more confident that the administration’s policies increase upside risks to the inflation outlook in the years ahead. In fact, we believe that the upside risks to inflation are higher now than at any other point since the financial crisis. In this environment, and even after their recent widening, TIPS breakevens and inflation swaps can serve as a source of relatively cheap insurance.
We start with the assumption that Trump’s main objectives are to deliver on his campaign promises to increase employment in the manufacturing sector, boost overall growth and improve national security (particularly in the area of domestic terrorist threats). With these goals in mind, his immediate policy priorities are renegotiating trade agreements and pressuring US firms to return manufacturing production to the US, lowering corporate and household tax burdens, reducing regulation of the economy, imposing restrictions on new immigrants while also increasing the pace of deportations of undocumented workers, and improving border security. Of these policy thrusts, immigration, trade, and fiscal policy all have the potential to boost inflation in the years ahead, thus we take them each in turn in the following sections.2 We then conclude with an assessment of how to position in inflation markets in light of the inflationary impulses that could stem from the administration’s policies.
Since the inauguration, Trump has backed away from some of his more disruptive campaign pledges regarding immigration, most notably his promise to apprehend and deport all illegal aliens. We never viewed this pledge as feasible, even if implemented over a number of years, given the sheer expense to the government, challenging logistics, and potential for civil disorder. Still, the administration’s immigration policies are very likely to curtail growth of the labor force, which could put upward pressure on wages and inflation. For example, the administration already appears to be moving away from the so-called “catch and release” policy of prior administrations. Under catch and release, illegal immigrants who did not pose a terrorist threat and who had no criminal record were not prioritized for deportation, with the de facto effect of letting such individuals remain in the country. The end of this policy implies an increase in the pace of deportations even beyond the increase seen during the Obama administration. In addition, Trump has already attempted to implement immigration restrictions to reduce the risk of terrorists entering the country. He has also gone so far as to discuss limiting or eliminating visa programs for higher-skilled workers in order to preserve jobs for US citizens. The new Attorney General also has a long history of advocating immigration restrictions, which further increases our confidence that the next several years will see increased deportations of undocumented workers and restrictions on new immigration. In addition, some foreign workers may look to other countries if they view the US as a less welcoming environment in which to work and raise a family. In turn, global US firms may respond by increasing their recruiting efforts at their foreign offices at the expense of hiring in the US. All told, the immigration policies of the new administration will result in slowing labor force growth at a time when the economy is already quite close to full employment. This suggests potential for additional upward pressure on wages and inflation as labor market conditions tighten further.
Much of the focus on President Trump and trade policy revolves around his campaign pledges to introduce relatively high tariffs on other countries viewed as engaging in unfair trade practices. We do not see the immediate imposition of tariffs as the major thrust of trade policy. Still, none of this changes the fact that Trump appears to favor protectionist policies with a goal of boosting US manufacturing employment. In addition, it is difficult to understate the importance of trade and manufacturing jobs to Trump’s political base. Combining his long-held policy preferences and the political necessity of resuscitating manufacturing employment, we expect trade policy to remain squarely in the spotlight throughout 2017. The administration will quickly move forward with renegotiating multilateral trade deals such as NAFTA, and will consider repealing deals and imposing tariffs if negotiations eventually falter. In addition, we expect Trump to continue to cajole US firms to halt offshoring of production and employment, including the threat of tariffs on specific goods to achieve these ends. The fact that a number of Trump’s key cabinet members and advisors have been critical of the trade and currency policies of major trading partners, and have also expressed support for the use of tariffs, provides a clear indication that this administration will move trade policy in a more protectionist direction. It is exceedingly difficult to predict the exact contours of trade policy in the years ahead, but the protectionist inclinations of Trump and his policy team, combined with the political necessity of returning manufacturing jobs to the US, at the very least warrant a higher inflation risk premium.Download to read more