Viewpoint
October 18, 2024 | 15:10
October 18, 2024
Economics
Economics
Economics
Economics
Economics
Economics
The Softest of Soft Landings |
| I think I’m going to have to start calling it the ‘down-pillow’ landing. The narrative on Wall Street and at the Federal Reserve is shifting rapidly. August concerns about a hard landing for the labor market and economy have reversed to such a visible extent that we are now forecasting the softest of soft landings in 2025. Indeed, some may see it as no landing at all. There is a growing risk of a real acceleration in aggregate demand that could spark another round of inflation pressures that prematurely sidelines the Fed from rate cuts next year. Much depends on the outcome of the election and outlook for federal spending and tax policy. |
| Fears of a hard landing started to evaporate with the large upward revisions to real personal disposable income growth that occurred back in September which showed consumers have been able to squirrel away far more savings than previously thought. Then, earlier this month, the September payroll report revealed an acceleration in job and earnings growth with a commensurate decline in the unemployment rate. Now, the last pieces of the third quarter consumer spending puzzle are coming into clearer view, and are really helping the growth picture. Retail sales after adjusting for inflation grew at nearly a 5.0% average annualized pace over the past three months. September sales volumes rebounded to a robust and better-than-expected 3.1% annualized pace after slumping 1.5% in August. Though volatile month-to-month, and with consumers clearly rotating spending categories, the overall real retail sales trend remained firm in the third quarter (Chart 1). With the final month now in our hands, we are lifting our already robust forecast for Q3 real consumer spending growth from 3.4% to 3.7%, about a third faster than the second quarter’s 2.8% annualized pace. There is little doubt the sharp deceleration in CPI inflation to a paltry 1.2% annualized pace in the third quarter with a big decline in gasoline prices is helping to rekindle consumers’ willingness and ability to spend (Chart 2). Add in realized and projected Fed rate cuts, strong corporate earnings growth over the past year, and record-high stock prices to the economic outlook, and it’s getting nearly impossible for the bears to make their case. Who said economics is a dismal science? This should put third quarter real GDP growth at a 3.0% annualized pace for a second consecutive quarter, up from our previous forecast of 2.2%. Beyond Q3, the GDP and consumer spending growth outlooks are also brightening for Q4 and into the first half of 2025 (Chart 3). Our baseline forecast for U.S. GDP growth in 2024 is 2.8%, just a touch below 2023’s 2.9% pace, and a still-sturdy 2.1% in 2025. No doubt there are hurdles ahead, with the upcoming election being a prominent near-term one. But it appears the U.S. economy is still operating on one of the firmest foundations for continuing growth in recent memory. Unfortunately, that means investors will also need to keep an eye on evolving inflation trends and the possibility of rising long-term interest rates. Both are potential party crashers in 2025. |
2024 Election: Macro and Market Impacts |
| Key messages
Potential macro and fiscal impactsRegardless of who wins the White House and which party controls the House and Senate, we assume that most of the expiring Tax Cuts and Jobs Act measures will be extended beyond 2025 to avoid a large economic impact. The Congressional Budget Office (CBO) estimates that the cost through FY2034 of extending the expiring measures would add $4.6 trillion to the cumulative deficit [1]. Absent an extension, the impact on after-tax personal incomes in 2026 is estimated at $290 billion. To the extent the latter are reflected in higher withholding taxes and lower consumption to start the year, there could be as much as a 4-ppt hit to annualized GDP growth in 2026 Q1 and a 1-ppt headwind for the full year. For this reason, there would likely be strong bipartisan support to extend most of the tax cuts. Even before any new proposals, the CBO projects the 10-year cumulative deficit will amount to $22.1 trillion, or $2.2 trillion per year (averaging 6.3% of GDP). This will cause the federal debt held by the public, which is close to 100% of GDP currently, to exceed the previous post-war record high of 106% by 2027 and climb to 122% in 2034. The debt could rise even faster if it puts upward pressure on interest rates. The rising debt will constrain fiscal flexibility and risks a fiscal crisis if bond investors demand a higher premium to lend to the government. The Penn Wharton Budget Model (PWBM) suggests that the U.S. debt could become unsustainable if it rises to 175% of GDP [2]. While the country is a long way from that tipping point, the debt ratio can rise sharply during economic downturns—it jumped 30 ppts in the four years after the start of the Great Recession and 18 ppts in the similar period after the COVID-19 pandemic. Scenario 1: Democrats control both the White House and Congress |
| The Committee for a Responsible Federal Budget estimates that Harris’ proposals would increase publicly held debt by an additional $3.5 trillion from 2026 to 2035 relative to a status-quo baseline [3]. The federal debt would rise from around 100% of GDP currently to 133% in 2035 (Chart 1). The PWBM estimates that expanding the Child Tax Credit and Earned Income Tax Credit, permanently extending the tax credit that lowers health insurance premiums, and providing down-payment support for first-time homebuyers could increase the 10-year primary deficit by $1.2 trillion. But negative economic feedback effects from raising the corporate tax rate from 21% to 28% would boost the shortfall further to $2.0 trillion [4]. This analysis does not include potential higher taxes on wealthy households, which could result in a smaller primary deficit to begin with. The PWBM suggests that 95% of Americans would see lower taxes, while high-income earners would pay more taxes [5]. |
The higher budget deficit would provide a modest economic boost, with a partial offset from higher taxes. The Tax Foundation estimates that raising the corporate tax rate to 28% would reduce long-run GDP by 0.6%, largely by curbing business investment [6]. The economic lift under a Democrat sweep would likely not be large enough to materially alter the inflation or interest rate outlooks. Scenario 2: Republicans control both the White House and CongressThe Committee for a Responsible Federal Budget estimates that Trump’s proposals (excluding the removal of the cap on state and local tax deductions (SALT) would increase publicly held debt by an additional $7.5 trillion between 2026 and 2035 from the baseline, or almost twice as much as Harris’ plans [7]. Trump’s promised extension of the 2017 tax cuts to households earning over $400,000 adds $2.35 trillion to the debt, and the reduction in corporate tax rates to 15% adds $0.2 trillion. The federal debt would rise to 142% in 2035 (Chart 1), or 9 ppts higher than under Harris’ plans. A separate study suggested that removing the cap on SALT deductions would reduce federal revenue by up to $1.2 trillion over a decade [8]. The PWBM estimates that extending the 2017 tax cuts in their entirety, eliminating taxes on Social Security benefits, and lowering the corporate tax rate to 15% from 21% would increase the 10-year primary deficit by $5.8 trillion. The net positive economic feedback effects from lower taxes would reduce this to $4.1 trillion. This latter figure is $2.1 billion higher than under Harris’ proposals [9]. The Tax Foundation says reducing the corporate tax rate to 15% would lift long-run GDP by 0.4% [10]. However, it also estimates that a 10% across-the-board tariff would raise taxes on American consumers by more than $300 billion a year and reduce U.S. GDP by 0.7%. Retaliatory action on U.S. exports would reduce GDP a further 0.4%, for a total reduction of 1.1%. A new 60% tariff on all imports from China would increase U.S. taxes by over $200 billion and lower GDP even further [11]. The Peterson Institute for International Economics estimates that higher tariffs (including a broad 20% increase) would overwhelm the lift from fully extending the 2017 tax cuts [12]. The Wall Street Journal recently cited one estimate that the average U.S. tariff would jump to 17% from 2.3% in 2023 and 1.5% in 2016 due to a 60% duty on China and 10% levy on other countries, the highest since the 1930s. BMO Economics believes the U.S. economy could see an initial material lift from corporate tax cuts and a larger budget deficit, but the adverse impact from tariffs and a potential trade war could eventually mitigate the gains. Less immigration might also undermine employment growth. Inflation, interest rates and the U.S. dollar would likely be higher than in the other three scenarios. Equity markets might rejoice initially at the prospect of lower corporate taxes, less regulation, and a firmer economy (recall, markets rallied immediately after Trump’s 2016 win). However, a possible trade war and credit-rating downgrade could lead to increased volatility in markets. Looking back at past election cycles, the S&P 500 has only slightly outperformed when a party controls all levels of government. Scenario 3: Democrats win the White House but Congress is dividedFor the most part, the status quo would prevail, implying little net impact for the economy and markets. BMO Economics would likely not need to materially adjust its economic forecast. Scenario 4: Republicans win the White House but Congress is dividedTrump would be free to pass most trade protectionist measures as the president has almost full discretion to impose tariffs on nations judged to have an unfair trade advantage over U.S. firms or that pose a national security threat. However, imposing a broad tariff on all countries could run into judicial resistance. Higher tariffs would have a negative impact on the economy, especially if they were met with retaliatory actions. While the inflationary impact would likely be partly tempered by a firmer U.S. dollar, disruptions to supply chains could lead to higher costs and prices. Depending on whether the economic or inflation impacts dominate, the Fed might need to adjust its policy stance accordingly. This might be the worst-case scenario for equities, as investors face the uncertainty and fallout from increased trade protectionism without the benefit of a fiscal boost to growth. A Trump administration could pose a threat to the continent-wide free trade agreement. A country can pull out of the USMCA with six months’ notice, though it is unclear whether congressional approval is required. The agreement also comes up for review in 2026, when members may decide whether to renew it beyond the pre-set termination date of 2036. Trump has already sent notice that he will push for changes during the review. Threats to the agreement’s existence would harm business investment, especially in the two smaller nations. Trump also would not require the approval of Congress in order to implement some deregulation measures. Moves to lower bank capital requirements could lead to additional lending and give the economy a slight lift. The Inflation Reduction Act, and the suite of tax credits that it provides for electric vehicles (EVs) and other clean energy technologies, could be heavily modified. The credits have been in the Republicans’ crosshairs since day one. Even if Trump wins but Congress stays divided, there are executive actions that he could use to narrow the interpretation of the guidelines and repeal some credits. Other considerationsUnder a split Congress, the party controlling the Senate has the power to approve or reject the President’s nominations for ambassadors and Supreme Court judges, possibly casting a long-term influence over economic and social issues. Donald Trump appointed Fed Chair Powell in 2018 but says he will not reappoint him upon expiration of his second term as chair in early 2026. If Trump wins and the GOP controls the Senate, he could handpick nominations to the Fed’s Board of Governors, which might increase uncertainty for investors. The federal debt ceiling becomes binding again on January 2, 2025, with Treasury resorting to “extraordinary measures” to keep the government financed for a short while. The debt limit will eventually need to be lifted early next year, and a divided Congress would pose the usual challenges. [1] https://www.cbo.gov/publication/60271 [^][2] https://budgetmodel.wharton.upenn.edu/issues/2023/10/6/when-does-federal-debt-reach-unsustainable-levels [^][3] https://www.crfb.org/papers/fiscal-impact-harris-and-trump-campaign-plans [^][4] https://budgetmodel.wharton.upenn.edu/issues/2024/8/26/harris-campaign-policy-proposals-2024 [^][5] https://www.cbsnews.com/news/kamala-harris-platform-policy-positions-2024/ [^][6] https://taxfoundation.org/blog/trump-harris-corporate-tax-proposals/ [^][7] https://www.crfb.org/papers/fiscal-impact-harris-and-trump-campaign-plans [^][8] https://www.wsj.com/politics/elections/trump-salt-state-local-tax-deductions-aff00b27 [^][9] https://budgetmodel.wharton.upenn.edu/issues/2024/8/26/trump-campaign-policy-proposals-2024 [^][10] https://taxfoundation.org/blog/trump-harris-corporate-tax-proposals/ [^][11] https://taxfoundation.org/blog/donald-trump-10-percent-tariff/ [^][12] https://www.piie.com/research/piie-charts/2024/trumps-bigger-tariff-proposals-would-cost-typical-american-household-over [^] |
Appendix: Key Party Proposals
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