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Wednesday, 13 December 2017

Welcome to the Trump inflation

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  • James Saft - June 2014

Americans did not elect a fiscally moderate candidate; America elected Donald Trump with his combination of tax cuts, infrastructure spending and attacks on trade deals.

Republicans rode Trump’s coat tails and promises into maintaining control of Congress, implying they may not act as much of a check on the new president’s will.

Unsurprisingly, the bond market sees this as inflationary.

Stock markets, as they tend to, are surging as they discount the rise in future cash flows from more spending and lower taxes but wait until rates rise sharply to impose a penalty on the value of those earnings.

Given a choice, the right move is almost always to believe bond markets.

Ten-year US government note yields jumped past 2% in the largest such move in three years while the S&P 500 gained 1%.

If the infrastructure spending actually comes, as opposed to just handouts to the well-off via tax cuts, the irony is that Trump’s program is not too far from what central bankers have been asking for, though they have not enjoyed and will not enjoy the verbal abuse.

This is not to say that a Trump economic plan, once it is clear, is sure to spur growth; if it includes imposing tariffs and backing away from low-friction trade it will do the opposite. Such a plan would be inflationary, and like a Cubs fan who asks for a World Series before they die only to expire just after, Fed officials might get the chance to restore normal interest rates but end up regretting the wish.

The Trump of the late-night acceptance speech was not the fire-breathing, NAFTA-destroying breaker of idols of the campaign trail.

That reassured markets, and their recovery from the panicked midnight sell-off is a big reason fed fund futures still see a three-in-four chance of a rate hike at the December Fed meeting.

“The US will move to a fiscally accommodative stance. Whilst President-elect Trump may be somewhat constrained by a Republican-controlled House of Representatives, it’s safe to assume we will see tax cuts, infrastructure and defense spending,” Stefan Isaacs, a bond fund manager at M&G Investments, said in a note.

“With an economy at close to full employment this will prove inflationary in the medium term and yield curves will continue to exhibit a steepening bias.”

If Trump returns to his campaign talk and imposes tariffs, yields and inflation both would push further north.

Proof in pudding

For at least the time being, equity investors will enjoy the expectation of higher growth, though the same shouldn’t be true for property, which is highly sensitive to the rates of interest used to fund its purchase.

There is a possibility that the old-guard Republicans led by Speaker of the House Paul Ryan may refuse successfully to sign on for unfunded tax cuts and spending increases. Given the backlash both in the US and Britain, which voted to leave the EU for a similar set of reasons as spurred Trump voters, that would be an unusually brave move in a politician.

Bet, as the bond market is doing, that Trump will increase the deficit and spur inflation. Even before the shock of the election, the Committee for a Responsible Federal Budget was forecasting that President Trump would increase debt to more than 100% of annual output by 2026.

“The key question will be how central banks will accompany this shift in the policy mix, and how bond markets will price the increased risk to inflation and financial stability. These two questions give rise to possibly the two most under-appreciated risks for 2017: bond markets and central banks’ credibility,” Didier Saint-Georges of fund manager Carmignac wrote clients.

We may have heard the last for a while of any experiment in a “high-pressure economy,” a phrase used by Fed chief Janet Yellen to denote allowing inflation and growth to run a bit hot in an effort to make up ground lost since the crisis. Fooling around with new and potentially inflationary policy under a loose-cannon president, one who accused the central bank of political bias, seems unlikely. The Fed will protect its credibility with rate rises if the fiscal policy mix and inflation warrant.

The chances that the US will return to a more “normal” interest rate in the next two years just got a lot higher. Less clear is whether higher rates will come with an increase of growth, or with too much inflation and a fall in asset prices.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

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