Monetary Policy & Inflation | US
This article is only available to Macro Hive subscribers. Sign-up to receive world-class macro analysis with a daily curated newsletter, podcast, original content from award-winning researchers, cross market strategy, equity insights, trade ideas, crypto flow frameworks, academic paper summaries, explanation and analysis of market-moving events, community investor chat room, and more.
Summary
- We travel into the future and publish a policy letter from the Treasury Secretary nominee to President-elect Donald Trump arguing that:
- Inflation should be kept below 3% through:
- Keeping policy changes simple and predictable.
- No increase in the budget deficit.
- Strong competition policy.
- Letting the Fed be the Fed.
- Productivity should be raised through deregulation and industrial policy targeting services rather than manufacturing.
- Workers’ income share should be raised through low skill immigration restrictions and stronger unions.
Market Implications
- The fixed income selloff accompanying rising odds of a Republican sweep could be overdone because Trumponomics is likely to be more rational than media conveys.
- I still expect the Fed to cut twice in 2024, roughly in line with market pricing 1.7 cuts.
- Long term, the Fed may have to revise its easing plans, though this revision would be unlikely before the 5 November US election.
‘Trump should be taken seriously but not literally.’ Anonymous
Raising Families Income Overarching Objective
Dear President-elect Trump,
I am honoured and humbled by your decision to nominate me as Treasury Secretary. I will support your administration to the best of my abilities and work with you to further the wellbeing of our fellow Americans.
In anticipation of our meeting, I have prepared a broad policy agenda for your review and discussion.
Our overarching objective should be an increase in median family real income (Chart 1). As you can see, real family income grew by 5% annually up to 1970 but by 0.5% annually for the following 40 years, despite the greater openness of the US economy. It is only in the mid-2010s, largely due to the policies you initiated, that real income growth picked up again.
By contrast, real family income stagnated under the outgoing Biden administration, which was a big driver of voter dissatisfaction.
I would like to propose a three-pronged strategy.
Keeping Inflation Below 3%
Mr President-elect, you are a disrupter. Your policies will deeply change the functioning of the US economy to the greater benefit of the American people. Nevertheless, the disruption will carry transitional costs and implementation risks.
The most important short-term risk is an inflation acceleration. This would be negative for the stock market, bond market, the residential investment recovery and for real wages.
Real wages fall when inflation accelerates, largely because wages get adjusted more slowly than prices of goods and services (Chart 2). Real wage growth was negative during 2021-23, which explains why real family incomes only recovered their pre-pandemic level in 2023 and was a key reason why Americans voted out the Biden administration.
Inflation acceleration at the outset of your reform program is unavoidable but can be contained.
The impact of the tariffs on inflation has been greatly exaggerated. The US is a domestic-driven economy. Consumer goods imports, excluding cars, represent only about 5% of total consumer spending with imports from China accounting for about 40% (foreign cars account for another $20bn or 0.1% of consumer spending). Assuming a worst-case scenario where all the tariff increase is passed to the final consumer, a 60ppt tariff hike on imports from China and a 10ppt hike on imports from other countries could increase consumer price indices about 150bp.
This is a relatively large increase but in the short term its impact on consumer real income could be offset by using the extra revenues generated from tax rebates. Long term, without a second-round effect, there would be no impact on inflation.
Consumption goods account for only about one fourth of total goods imports, with the remainder consisting of capital goods and various inputs, so there will be inflationary pressures coming through the production process.
But these could be contained through a combination of:
Keeping Our Policy Framework Simple and Predictable
This will give businesses time to adjust. Tariff increases could be implemented, for instance, in two pre-announced steps over a 12-month period. Furthermore, we should tell our trade partners that, if they do not retaliate, we do not intend to raise tariffs further. Many of our partners have benefitted from the US military umbrella for decades – at great expense to the US taxpayer. I suggest we leverage those relationships.
Similarly, the planned enforcement of immigration laws would need to proceed in step as expelling the undocumented migrants currently in the US could bring about a labour shortage worse than experienced during the pandemic.
No Budget Deficit Increase
The state of public finances is appalling with public debt at, and budget deficit close to, WWII highs (Chart 3). With the economy already at risk of overheating, adding to the deficit would raise inflation and lower real incomes. An overheating economy would also add to businesses pricing power and to the risks of transmission of higher import costs to consumers.
We should make the American public fully aware of the terrible budget situation we are inheriting and fully fund tax cuts with expenditure cuts.
Strong Competition Policy
We need to strengthen competition policy so that businesses cannot pass on the higher costs of imports to consumers. Large businesses can absorb those costs:
corporate profits as a share of income are the highest since WWII (Chart 4).
The income share of profits has been rising since the 1990s, despite the increasing openness of the US economy. This is a clear sign globalization has failed to prevent the increased concentration of the US economy.
This trend that has been well documented by academics and policy makers. In 2019, monopolies were estimated to cost every American $300 a month. The costs are likely much higher now.
Therefore, we should strengthen the competition policies implemented by the Financial Trade Commission and the Department of Justice. These will raise real incomes for American families and prevent second round price effects from our tariffs policies.
Let the Fed Be the Fed
The Fed matters much less for the real economy than conventional wisdom would have us believe. The transmission of monetary policy tightening to the real economy is limited.
The Fed also has no intention of crashing the economy to hit their inflation target. For instance, they started their easing cycle with a 50bp cut despite strong growth and low unemployment.
Thirty years ago, then-professor Bernanke argued monetary policy tightening gets transmitted more through lower asset prices than higher borrowing costs. I believe this is still true, but I also believe the Fed has no appetite to crash either housing or equity markets. Since the Fed started tightening in 2022, equity markets have reached new highs!
Even if the Fed delays its planned rate cuts or stops cutting altogether, the impact on the real economy is likely to be muted, especially given our other policies will lift productivity, growth and incomes. Also, a stable Federal Funds Rate could stabilize inflation expectations.
I believe inflation below 3% and stable would not trigger Fed tightening. Markets would also view this as price stability. It is hard to argue 3% inflation is worse than 2%. The economy will adjust if inflation remains stable.
Keeping inflation stable will not prevent us raising productivity and incomes.
Raising Business Productivity
Globalization did not deliver lasting productivity gains (Chart 6), the only sustainable way to raise the standard of living.
By contrast, your deregulation plans could raise business productivity. A recent study estimates regulations cost US businesses $3tn in 2022, up from 2.6tn in 2014. Federal register pages spiked under the Biden administration, even though the pandemic ending should have seen a lighter regulatory burden (Chart 7).
In addition to lightening the regulatory burden, we should also implement policies directly targeting productivity.
I do not advocate continuing the Biden administration’s industrial policy and handouts to private manufacturers. These had no discernible impact on manufacturing employment (Chart 8). Manufacturing wages have been falling relative to services!
The handouts have basically funded private industry acquisition of robots rather than the mass creation of well-paid blue-collar jobs that no longer exist. Besides, manufacturers will already benefit greatly from your deregulation and tariffs.
Rather, since most jobs will come from the services sector, I suggest we implement an industrial policy targeting services, along the lines suggested by professor Dani Rodrik who, like you, has been a critic of globalization long before it became fashionable.
The strategy would involve the provision of business assistance programs through public/private partnerships. Also, an agency along the lines of the highly successful Defense Advanced Projects Agency (DARPA) would be created to foster services innovation and leverage US global IT leadership.
Precedent exists for such an ‘extension’ strategy. It has been implemented in the agricultural sector since the 1910s with enormous success.
But raising productivity will not benefit American families unless we ensure the gains are passed on to workers.
Stronger American Workers’ Power
Mr President-elect, the American people have spoken. They no longer want the tax and redistribute policies of the Biden administration. These policies have led to ever growing public expenditures yet have not prevented wage growth from falling well below productivity growth (Chart 9).
Instead, American workers want to earn wages that reflect their contribution to the US economy and afford them a decent standard of living.
An end to large-scale, low-skill immigration will help restore workers’ income share. This is visible in the impact of the 2021-24 undocumented migrant surge that came with a decline in the wage income share and in the spread of low over high wage growth (Chart 10).
By contrast, the immigration restrictions implemented during your first presidency saw low wage workers gain relative to higher paid workers and the wage income share stabilize.
This is unsurprising since low skill immigrants compete mainly with low wage workers. In addition, we should implement a skills based immigration policy targeting strategic skills currently in short supply.
Lastly, raising workers’ income share requires stronger unions. Private sector union density has been declining for the past 40 years which has been a key driver of the secular decline in workers’ income share (Chart 11). This decline reflects largely decades of pro-employer law and regulations.
Unions need not be partisan as we saw when the Teamsters refused to endorse a specific presidential candidate. They need not be anti-business either. In Germany unions are represented on the boards of large employers. If we want to raise families’ incomes, employers must accept a better-balanced sharing of the economic pie.
US conservatives, including Vice President-elect James Vance, have made an eloquent case for stronger unions and I think we should explore legislative and regulatory initiatives to support stronger, accountable and non-partisan unions.
Mr President-elect, I would like to thank you again for the honour of serving in your administration. I believe we have a unique opportunity to move the US economy to a faster and fairer growth path and realign US politics for the next generation.
Signed: Your faithfully (and perhaps naively), Treasury Secretary
Market Consequences
Fixed income markets have been selling off in line with the increase in the betting odds of a Republican sweep (Chart 12). This could partly reflect click baiting media amplifying every extreme or shocking statement made by Trump (who is great copy).
The purpose of this note was to show the sell off could be overdone because Trump economic policies are unlikely to be as irrational as the media imply.
Even with a Republican sweep, the Trump economic team will be unlikely to implement extreme policies that would threaten macroeconomic stability since these would carry negative electoral consequences in 2026 and beyond.
Also, Trump’s core policies, namely tariff increases, tax cuts, and immigration restrictions could be implemented in a way consistent with contained inflation and faster trend growth.
Short term, I still expect the Fed to cut twice in 2024, roughly in line with market pricing 1.7 cuts. Long term, the Fed may have to revise its easing plans, though this revision would be unlikely before the 5 November election.
Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.