What Trump’s policies could mean for the Fed

Fed Performance Assessment

• Kaplan rates the Federal Reserve's execution of a "soft landing" as a success for financial markets and affluent investors, noting that the economy continues to grow despite high interest rates.
• He assigns a lower grade to the Fed's initial response (pre-pivot), attributing the lag in raising rates and stopping bond purchases to the subsequent need to combat "sticky" inflation caused by post-COVID fiscal stimulus.
• A significant portion of the workforce (65–70 million workers earning under $55,000 annually) has suffered a 20–25% loss in purchasing power due to cumulative price increases outpacing wage growth, a factor likely influencing recent election outcomes.
• Fiscal policy has been dramatically more accommodative than historical norms, with U.S. government debt rising from 70% of GDP pre-COVID to over 100% post-2021.
• Large directed spending programs, including the Inflation Reduction Act, Infrastructure Act, and CHIPS Act, created outsized fiscal spending that necessitated higher and more prolonged rate hikes (reaching 5.25%–5.50%).

Regulatory and Political Dynamics

• Kaplan observes distinct shifts in supervisory stringency depending on the administration: supervision was more "constructive and benign" under Trump (2016–2020) compared to the "stepped up" supervision experienced under the Biden administration.
• He anticipates that while the Fed's rate-setting process will remain insulated from political pressure, regulatory policy will undergo significant changes under the new administration.
• There is a potential future debate regarding the balance sheet, where the Treasury may seek increased authority alongside the Fed, challenging the Fed's traditional autonomy.

Structural Economic Shifts and Policy Risks

• The economy is transitioning from cyclical factors to structural shifts, driven by potential changes in labor force growth, technology adoption, regulatory reform, and the energy transition.
• Labor Force: A shift from immigration-driven growth (historically ~3% GDP growth) to potential labor contraction or stagnation could stretch labor supply and increase service sector inflation.
• Regulatory Environment: A pivot from heavy regulation to a focus on productivity growth and deregulation could be disinflationary by boosting efficiency.
• Energy Sector: Policy pressure on oil and gas production is expected to lower pump prices, exerting downward pressure on inflation for low-to-moderate income families.
• Tariffs: While tariffs on goods may increase, their inflationary impact is debated due to consumer substitution effects; their net effect may depend on whether they successfully stimulate domestic production compatible with available labor.

Forward-Looking Market and Fed Expectations

• Kaplan advises market participants to view the Fed as "risk managers, not prognosticators," warning against rigid expectations given the current lack of clarity on new administration policies.
• Full clarity on structural policies (tax, immigration, regulation) may not be available until spring 2025, creating a "puzzle" that requires fitting multiple moving parts together.
• Rate Decision Outlook: While a rate cut in December remains the most likely scenario, Kaplan suggests the Fed should treat it as a "game-time decision" to await the November jobs report and clearer policy signals.
• He cautions that the Fed could pause rate cuts if the labor market proves tighter than expected or if the puzzle of structural changes indicates higher inflation risks.
• Growth vs. Earnings: A strategy of "reprivatizing the economy" (reducing direct government spending) might lower top-line GDP growth to 2.0%–2.5% from current levels but could boost corporate earnings through regulatory relief and tax reforms.
• Investors should prioritize monitoring labor force dynamics and the pace of technology-enabled disruption (e.g., automation replacing labor) as the primary indicators of future inflation and growth trajectories.

Episode Details

• Date Recorded: Monday, November 11, 2024.
• Host/Interviewee: Alison Nathan (Goldman Sachs) and Rob Kaplan (Goldman Sachs Vice Chairman, Former Dallas Fed President).
• Next Episode: A four-part series on sports and finance dynamics.