A virtual consensus exists about the probability of a fiscal stimulus under a Trump presidency. Most only debate its size and timing. But that doesn’t appear to be dampening market expectations, with the stock market continuing to set new highs amid a selloff in the bond markets. Much of this market exuberance, presumably, stems from the view that the fiscal stimulus will ignite the economy. Which is perhaps why Bank of America Merrill Lynch is advising caution.
“We expect fiscal stimulus and stronger growth in the medium-term, but we worry lags will be longer than market expectations,” the bank said in a research note Dec. 5. “The short-term risk, in our view, is for disappointment given the complicated process of implementing tax reform. The medium-term risk is for a boom-bust cycle as the economy overheats from stimulus.”
The bank is also concerned that the markets might be too upbeat on the timing of the stimulus package. In addition to a lag in how the stimulus affects the economy, and in turn the markets, two key questions remain – one political and the other economic.
Trump’s Fiscal Stimulus Plan
The first is this: Can Trump’s fiscal stimulus plan, the largest in US history, win over the fiscally conservative House of Representatives?
The bank’s Ethan Harris characterizes Trump’s likely fiscal policy as “unstoppable force meets an immovable object,” and expects it to be the “most fascinating narrative around the election,” from a near-term growth perspective.
Even a slimmed down version of the Republican president-elect’s tax cut plan would add .4 trillion to .9 trillion to the budget deficit over the next 10 years, according to the Tax Foundation. Some of it would, of course, come from the anticipated higher growth but when one adds big infrastructure plans, increased defense spending, the Mexican wall, enhanced immigration enforcement, etc., the ten-year tag could be trillion, according to Harris.
“It is hard to see House Republican’s agreeing to anything close to this,” he wrote in his research note Ethanomics. “Fiscal conservatives did very well in the house elections, with an increase in the share that associates with the Tea Party and with Paul Ryan retaining the speakership. This is the same group that threatened to default on the debt in 2011, delayed resolving the fiscal cliff in 2012 and shut the government down in 2013, all in the name of fiscal discipline.”
Even assuming that the Republican House may be more flexible with a Republican in the White House, “we would expect them to do a 45-degree, not a 180-degree turn on fiscal discipline,” he added.
Secondly, how much can economy at near full employment capitalize on a fiscal stimulus plan?
Stimulus will be most effective if there are underutilized resources — higher level of unemployment, unutilized capacity and perhaps stockpiles too. But that doesn’t appear to be the case.
Joblessness is at a nine-year low of 4.6%. The economy has been recovering since 2010, “growing at an average 1.0pp above our estimates of potential growth,” largely eliminating the output gap, the bank said.
Clearly, the economy is in the later stages of a business cycle and any stimulus risks of overheating the economy, and accelerating inflation.
By Bala Murali Krishna
