Given Trump’s upcoming policy guidance, there are reasons to believe that inflation could soon be on the rise. This begs the question, “Are we in a temporary inflation lull?
To answer that, let’s recap our current economic cycle of inflation starting in 2020, breaking down two waves of inflation: one led by demand and the other led by supply. Then, we’ll look at what impact Trump's policies could have on a potential third wave of inflation.
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Let’s start by saying this: forecasting the dynamics between monetary and fiscal policy is speculative. The Federal Reserve, like all economists and market pundits somewhere, believes that the new president’s policy choices will be inflationary and are perhaps giving themselves hedging room to not err in advance.
We experienced the first wave of inflation in this current cycle created by demand imbalance, led by the outbreak of COVID-19 in 2020. This was supplemented by a massive governmental stimulus.
The second inflation shock came with a deteriorating supply side. The world supply-demand imbalance was still reeling from closed borders caused by the pandemic. The Russia-Ukraine War deepened the supply imbalance starting in February 2022.
The Fed, in one of the fastest rate hikes in history, somewhat threaded the proverbial needle of a soft landing by June 2024. We have been experiencing a lull in inflation as measured by the traditional metrics of CPI and core PCE. Current inflation, as measured by core PCE, is at 2.7%, which is not much further from the Fed’s 2% inflation target. Clearly the Fed believes that policy is close to restrictive, resulting in 75 basis points of rate cuts (with speculation of another cut of 25 basis points in December). To us, this reveals that the Fed is more comfortable operating in an inflation target band of 2–3% instead of a strict 2% mandate. Also, with further hedging guidance from the FOMC and Chair Powell himself, that rate cut will be gradual.
Now comes President-elect Donald Trump with a resounding mandate to the Republican party. The wild card for the markets is how Trump’s policy choices will shape the economy moving forward. We have talked before about the impact of inflation based on policy decisions that seem to be pro-inflationary.
Is there a third wave of inflation waiting for us behind the currents of 2025? With all this build-up, we have an anti-climactic answer: we don’t know. Forecasting the impact of policies on the economy is tricky at best. From the current vantage point, we are leaning toward “yes, policy impacts could be inflationary.” For instance:
- Even if there is no mass deportation, immigration will slow. This affects the labor market and creeps into GDP.
- Tariffs on Chinese imports could be up to 60%, which would cause price escalations a decline in growth.
We think that the monetary policy rate and the Federal Reserve's search for r-star will result in a higher, longer-term rate because of the FOMC's more cautious approach.
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