Lessons From the Election

Pointers for Fed And Incoming Administration

Elections are over with a decisive victory for Donald Trump in the Presidential race. The supposedly apolitical Federal Reserve delayed its policy announcement for the first time so that its decision would not come out on the same day as the election results. Now that both events have taken place and we have seen the initial market reaction, there are some key takeaways that both the President-elect and the Fed Chairman may want to heed.

First, inflation, inflation, inflation. SriKonomics has repeatedly emphasized in weekly reports since 2021 that the extent of fiscal spending and monetary easing were unwarranted, and that inflation would not be “transitory.” Now, voters have signaled, unambiguously, that the pace of price increases is their foremost economic concern, even more than economic growth or jobs. Repeated victory marches by the Biden administration about the jobs that it had created through various stimulus programs were overwhelmed by problems resulting from the higher cost of groceries, childcare and basic services. The incoming Trump administration has to ensure that inflation does not get rekindled making it even more difficult to control.

Second, President-elect Trump will start his administration with sovereign debt at a record high 125% of gross domestic product, and the fiscal deficit at over 6% of GDP. I learned when I started my career more than 40 years ago that the “safe” maximum for the debt - GDP ratio would be 50%, and the safe ceiling for the deficit 3% of GDP! We will have to deal with these key ratios being at, or above, twice the danger threshold.

The monumental debt buildup since covid — despite no US involvement in wars or a crippling recession — has resulted in interest payments exceeding defense spending or Medicare expenses during the first seven months of the fiscal year (October 1, 2023 - April 30, 2024). With default on sovereign debt out of the question, the large share of interest expenses in total spending may force the Trump administration to postpone the tax cuts and subsidies that it had promised during the campaign.

What if the incoming officials decide not to worry about the debt or deficit and go ahead with fiscal easing? The warning bell sounded on Wednesday when the Treasury market reacted to the Trump victory with the yield on 10-year debt surging by 16 basis points within a few hours. I have publicly said before, and repeat here, that in the absence of corrective action the yield on the 10-year could go over 5%. That would take the mortgage rate up with it, putting a new damper on housing. Telling first-time home buyers that affordability is once again low would be no way to gain political popularity!

Third, a key plank of the Trump campaign proposals is to “punish” trade partners for the loss of US jobs by imposing new import tariffs. Numbers that have been bandied about include a flat minimum tariff of at least 10% on all countries, and a 60% tariff on Chinese products. It may make sense to use the threat of tariffs as a negotiation tool to obtain favorable decisions from countries, e.g., to make European countries pay more for their own defense rather than depend on US spending. Or, to make Chinese officials come to the negotiating table with proposals that are palatable. But it would be an entirely different ball game to actually impose sky-high levies.

US consumers would be the principal victims of the higher tariffs, with a portion of the tax being reflected in higher prices of essentials. There is a lesson from history on how this would work. The Smoot-Hawley Tariff Act of June 1930 had a laudable objective — to protect American companies and farmers. However, as trade partners retaliated with moves of their own against the United States — surprised?! — Smoot-Hawley is widely seen as having made the Great Depression deeper as well as worldwide. This key takeaway holds true almost a century later.

The election results have information to impart to the Federal Reserve as well. Although Chairman Jerome Powell has said repeatedly that the central bank does not take politics into consideration in making decisions, the Federal Open Market Committee delayed its meeting so that the officials could make their moves after finding out who won the Presidential race. Will Powell also recognize the importance voters placed on controlling inflation?

The FOMC made an ill-timed 50 basis point cut in the Federal Funds rate in September that raised long-dated Treasury and mortgage rates rather than lower them as the Fed had anticipated. That did not stop the FOMC from lowering the Federal Funds rate by another 25bp on Thursday even though the core measure of the Fed’s favorite inflation index stood at 2.7% in September, unchanged from August. By comparison, the Fed’s target is 2%.

Powell said at his press conference on Thursday that he will stick to his practice of not commenting on fiscal policy measures. Does he not remember the impact of such a stance during 2020 - 2022, when he and his colleagues lowered the Federal Funds rate to near-zero and doubled an already bloated Fed balance sheet? The combination of Fed measures and government spending boosted inflation to 40-year high levels.

Despite his protestations about staying out of politics — repeated at the press conference on Thursday — the Fed is very much a political entity. Just as a President needs to seek reelection or retire after four years, the Fed Chair holds his position for four years with the new President having the ability to remove him after his term ends — in Powell’s case, May 2026 — if he so chooses.

Therefore, under the current structure, a Chairman who would like to keep his job needs to be in the good books of the incoming President. To avoid this outcome and actually move the Fed toward political independence, I have repeatedly suggested in SriKonomics that the Fed Chair be named for a single six-year term and be ineligible for renomination. That way, the Chairman would have less reason to focus on the political calendar or to curry favor with the next President.

If you still believe that the President is a political entity but the Federal Reserve Chairman is not, I have something to offer you. I shall sell you the Golden Gate Bridge at a good price!

Dr. Komal Sri-Kumar

President, Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

November 9, 2024

Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.

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