Policy Changes and the Macro Outlook

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I’ve been running my own econometric model of the U.S. economy for almost 30 years now. The basic structure is simple. You start by forecasting the components of demand, that is to say, consumption, investment, trade and government spending. This gives you an initial projection of real GDP growth. You then feed this into labor market equations, along with some demographic assumptions, to forecast the growth in jobs, the unemployment rate and wage growth. All of this, along with assumptions about energy prices and the dollar, then drive forecasts of inflation. Given this outlook for growth and inflation, you make an assumption about the path for the federal funds rate and then run forecasts of other interest rates. With all of this in hand, you can forecast productivity, corporate profits, the federal budget deficit and household net worth. And then you go back to the start to see how all these changes impact your original demand forecast. You repeat the process until you arrive at a reasonably consistent solution.

There are, of course, many details to each of these steps and, over the years, I’ve tended to add complexity to the model rather than reduce it. This is the time of year when I most regret that tendency since, each fall, after the government releases its annual benchmark GDP revisions, I overhaul the model and add another year to the forecast. This is a very cumbersome process and this year I delayed it for a month or two on the grounds that the election might significantly impact the forecast – which it has.

Still, over the last week, I’ve had to bite the bullet and extend the forecast out to 2026, including some important assumptions about the effects of potential policy changes in Washington, particularly in the areas of tariffs, immigration and taxes.

The Forecast without Policy Changes

In order to assess the potential impact of policy changes, it makes sense to first consider what the forecast would have looked like in their absence. A year ago, we summarized our outlook for 2024 as 2-0-2-4, that is to say, 2% real GDP growth, zero recessions, inflation falling to 2% and the unemployment rate staying at or below 4%.

This forecast has worked out pretty well – we now expect fourth quarter data to show year-over-year real GDP growth of 2.2%, year-over-year consumption deflator inflation of 2.3%, an unemployment rate of 4.1% and we have, of course, avoided recession.

In the absence of policy change, the model suggests something very similar for both 2025 and 2026, with real GDP growth and inflation averaging close to 2%, the unemployment rate staying at 4% and the economy continuing to dodge recession.

However, this forecast is really the result of a fine balance among offsetting factors. Consumer spending is being boosted by positive real wage growth, improving consumer confidence and a continuing surge in wealth. That being said, slower job growth, rising consumer credit delinquencies and lower immigration (even before the change in administration) was set to slow consumer spending growth to 2.0% from the 3.0% achieved over the past year. Investment spending growth was also on track to moderate in a lagged reaction to higher interest rates, trade was set to detract from growth due to a high dollar and weakness overseas and state and local government spending was likely to grow more slowly following a delayed post-pandemic hiring spree.

This moderating economic growth would imply moderate employment growth of roughly 100,000 to 150,000 jobs per month. Given a drift down in immigration and stagnant growth in the native-born working age population, this should have been enough to hold the unemployment rate close to 4.0%.

Meanwhile, in the absence of policy change, inflation should also have been largely stable with consumption deflator inflation sticking close to 2.0% year-over-year after seeing a small bump higher over the next few months.

This view of the world is very close to that laid out by the Federal Reserve at its September meeting and would be consistent with a slow normalization of interest rates cutting the federal funds rate from a peak of 5.25%-5.50% to a range of 2.75%-3.00% by the summer of 2026.

Potential Policy Changes

So how might potential policy changes impact this outlook?

On tariffs, the President-elect has vowed to impose a 10% tariff on all imported goods and a 60% tariff on Chinese goods. However, roughly 38% of goods are imported from countries with whom the United States has a free-trade agreement, most notably Canada and Mexico, which bar this kind of unilateral tariff increase. If we exclude these countries, the average tariff rate on imported goods would rise from roughly 3.0% today to 11.8%, or an increase of 8.8%. However, we assume that because of negotiations with some trade partners, business pressures to exempt some commodities, and foreign suppliers and importers eating some of the cost, the average price of imported goods would only rise by half as much, or 4.4%, starting in the second quarter of 2025. With U.S. goods imports equal to 17% of consumer spending, this could, as a very rough estimate, add 0.7% to CPI inflation next year.

Tariffs would also reduce both imports and exports. Assuming that foreign nations retaliated with equivalent tariffs, both sides of U.S. trade could decline by equivalent percentages. Because the U.S. imports more than it exports this could, in theory, add to economic growth. However, the impact of a trade war in slowing the global economy and the uncertainty and disruption caused by a further need to reroute supply chains, would likely more than negate this effect.

On immigration, while campaign rhetoric was extreme, we expect actions to be less so. The newly-named “border czar”, Tom Homan, has emphasized that he will prioritize deporting undocumented immigrants with criminal convictions and final deportation orders. This group likely has much lower labor-force participation than other immigrant groups. Consequently, we do not expect a sharp decline in labor force from deportations.

That being said, the election may discourage people from crossing the border as well as dampening more traditional immigration. In addition, legal avenues to immigrate may be slowed or restricted as was the case in the first Trump administration. It is quite possible that the picture could change with the passage of an immigration reform bill. However, for now, we are assuming that a crackdown on immigration cuts labor force growth by 25,000 per month or 300,000 per year – or roughly a quarter of net immigration in the year ended June 2023.

On taxes, in 2025, we expect the omnibus reconciliation bill, which is the one budgetary vehicle with immunity from Senate filibusters, to contain very significant tax cuts. This bill will likely contain a full extension of the 2017 TCJA cuts that were set to expire at the end of 2025. The President-elect has also promised a cut in the capital gains tax from 21% to 15% for domestic production, a restoration of full expensing of R&D and equipment purchases, also for domestic production, removal of the cap on SALT deductions, deductibility of auto loan interest and exemptions from income tax for all social security, tips and overtime income. Based on calculations from the Committee for a Responsible Federal Budget, we estimate that a full implementation of these plans would add more than $5.0 trillion to the federal debt over 10 years, on top of a simple extension of tax policy as it is currently being implemented. This could amount to over $400 billion in additional annual fiscal stimulus and deficit financing, kicking in at the start of 2026.

However, Congress will very likely attempt to reduce the costs of these proposals. It could, for example, raise rather than eliminate the cap on SALT deductions and means test the tax breaks on social security, tips and overtime. For now, we are assuming an annual $200 billion boost in fiscal stimulus and deficits from changes in the tax code starting in 2026.

Implications for the Macro Outlook and Investing

Some would argue that we should also boost estimates of productivity from deregulation under a new Trump administration. However, any such gains are very hard to estimate and could be offset by the distortions caused by readjusting supply chains in reaction to tariffs, finding ways to define production as domestic, trying to replace deported immigrants, and maximizing the income that could be categorized as tips and overtime for taxes. So in incorporating policy changes into the forecast, we only, at this stage, include assumptions on the inflation hit from tariffs, the labor force hit from tougher immigration policy and the income and deficit impacts of tax cuts.

The net result of this is to somewhat destabilize a very stable forecast.

• Economic growth, would be largely unaffected next year, with real GDP rising by 2.2% year-over-year by the fourth quarter of 2025. However, powerful fiscal stimulus from tax cuts kicking in at the start of 2026 could boost year-over-year real GDP growth to 2.8% by the end of the year.
• Job growth, would also be relatively unaffected in 2025 but would pick up in 2026 in response to fiscal stimulus. Lower labor force growth due to less immigration would cut the unemployment rate to 3.9% by the end of 2025 and 3.6% by the end of 2026.
• Inflation, as measured by the personal consumption deflator, could rise to 2.7% year-over-year by the fourth quarter of 2025 in a one-time feed-through effect from tariffs and then drift down to 2.1% year-over-year by the end of 2026.

Meanwhile, the Federal Reserve, could, as the market now anticipates, put a premature end to its easing cycle with just three more 25-basis-point rate cuts, taking the federal funds rate down to a range of 3.75% to 4.00% by next summer and holding it there. Needless to say, our fiscal situation would worsen, with the federal budget deficit potentially rising from $1.8 trillion in fiscal 2024 to $2.7 trillion, or 8.4% of GDP, in fiscal 2026.

It should be stressed that all of this is highly speculative. We do not know the details on any of these policies or how aggressively the new administration will pursue them. That being said, on a very rough forecast, none of this spells disaster for the economy or markets in the short run and equities could directly benefit from a further reduction in the corporate income tax.

However, it does suggest that, barring a recession, long-term Treasury yields and mortgage rates are more likely to drift up than down from here. Moreover, further weakening our already stressed public finances adds long-term risk to any investment scenario. For this reason, and because both U.S. equities and the dollar have risen substantially over the course of this election year, now would be a good time for investors to consider broader diversification both among U.S. assets and around the world.

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