Trump and inflation

There are several good reasons to be worried.

Donald Trump still leads in most polls, and betting markets give him a better than even chance of winning the election this November. So it’s important to think about what his actual policies would be, and how these would affect the outcomes that Americans care about. Right now, the outcome Americans probably care about most is inflation. So we should get ahead of the game here, and think about how Trump’s policies would affect prices.

This is an inherently difficult exercise. Trump isn’t wedded to a particular ideology, and is often very open to persuasion — especially if you come bearing large checks for him and his businesses. Predicting whether he’ll follow through on his policy promises in a forceful and substantive way, or whether he’ll make a symbolic gesture and leave it at that, is always tough. But if we’re going to make an informed decision about who should be President, we need to take our best guess.

The basic story here is that there are three main ways Trump could increase inflation in the U.S.: tariffs, deficits, and pressuring the Fed to lower interest rates.

Tariffs and inflation

A number of people are warning that Trump will raise inflation by putting up high tariffs. For example, here’s Matt Yglesias:

[T]ariffs have a distinct inflationary impact…[Consider] a 10 percent tax on imported olive oil. That makes imported olive oil more expensive…But it’s also going to raise the price of domestic olive oil, because price competition from foreigners has diminished…[N]ow imagine doing this across the economy. The price of everything goes up.

Trump has promised a 10% tariff on all imports from all countries, a 60% tariff on all Chinese goods, and a 200% tariff on all cars made by Chinese-owned companies. Tariffs raise consumer prices — in economics terms, they represent a negative supply shock. Negative supply shocks reduce growth, increase unemployment, and push up inflation. So if you care about inflation, it’s reasonable to worry about this.

There are lots of uncertainties concerning just how much tariffs push up prices. To give just one example: Without action to reduce the dollar’s role as the world’s reserve currency, it’s likely that tariffs would result in the dollar getting stronger, which would allow Americans to buy imported goods more cheaply and would thus cancel out some of the effects of the tariff. It seems unlikely to me that Trump would take the dramatic, wrenching actions needed to devalue the dollar, so currency appreciation is one force in the economy that would “push back” against the effects of tariffs. (Of course if Trump did actually go ahead and devalue the dollar, that would produce even higher inflation.)

In fact, dollar appreciation in 2018 might be one reason why Trump’s tariffs in his first term didn’t push up consumer prices much for Americans — only by 0.2% total, according to one study.

Because of these uncertainties, different models arrive at different conclusions for how much Trump’s proposed tariffs would increase inflation. For example, Bloomberg’s economics team forecasts a total increase of 2.5% in consumer prices from all of Trump’s proposed tariffs, while Robinson and Thierfelder (2022) predict an increase of 6.7% from just the 10% global tariff alone.

This would be a one-time price increase, not a long-term rise in the inflation rate. But as we saw in 2021-22, even a temporary burst of inflation can make voters very unhappy for a while, and a 6.7% increase in consumer prices is nothing to sneeze at.

So the danger of tariff-driven inflation is real, but the effect would be transitory, and there’s a real possibility that it would be modest in size. Other potential Trump policies, however, could have bigger and longer-lasting effects.

Deficits and inflation

We tend not to associate Trump with inflation, because it was low in his first term. But that doesn’t mean his policies didn’t contribute to the inflation of 2021-22. The $2.2 trillion CARES Act and its $0.9 trillion follow-up in December 2020 handed out massive amounts of money to American households — even more than Joe Biden handed out in 2021. Americans initially saved most of that money instead of spending it, but in 2021 they started spending that saved-up cash. Most macroeconomists think that this spending binge contributed significantly to inflation in 2021 and early 2022.

Now, I supported those bills! In my opinion, Trump did the right thing here, because making sure that Americans weren’t financially ruined by Covid, and that the U.S. economy recovered quickly, were more important than keeping inflation low. But the impact of Trump’s pandemic spending does demonstrate two things:

1. Fiscal spending can contribute significantly to demand-side inflation

2. Trump doesn’t have much of an instinct for austerity

In fact, Trump’s distaste for austerity and lack of concern about deficits predates the pandemic. Thanks largely to Trump’s tax cuts, the federal deficit increased from 3.4% in 2017 to 4.6% of GDP in 2019. And austerity in general is not the kind of thing populist leaders do — they tend to hand out short-term goodies to keep themselves popular, even if this leads to greater pain for the citizenry in the long term.

So what would Trump’s deficit policies look like in a second term? In his post, Yglesias flags an analysis by the Committee for a Responsible Federal Budget, which shows how extending the tax cuts from Trump’s first term would increase the national debt:

Source: CRFB

Now, that’s not a huge increase, and the blue line for “current law” shows that Biden is already doing quite a lot of deficit spending. But it’s likely that Biden’s deficits are already contributing to stubbornly above-target inflation. As I wrote in a post back in April, macroeconomics theory tends to think that government budget deficits are inflationary:

It’s theoretically possible that deficits can be inflationary. In fact, this is how a typical New Keynesian macro model works. It’s also implied by a theory called the Fiscal Theory of the Price Level. So it might be the case that the U.S. government’s big deficits might be causing inflation to remain stubbornly above target.

Now as I noted in that post, macroeconomic theory isn’t always a great guide to reality. There are situations where governments have run up huge debts without sparking inflation — for example, Japan. But it’s certainly worth worrying that higher deficits under Trump would push up inflation.

And this problem is getting worse, because of rising interest costs. As the U.S. government rolls over more and more of its low-interest legacy debt from before the pandemic at the new, higher interest rates, it has to pay more and more each month just to service the debt. That is causing deficits to rise — we’re borrowing to fund the interest on our own borrowing.

Austerity is the only way to deal with that problem. Whether Biden and Congress are willing to engage in austerity after this election is an open question, but Trump’s record — and his general populist approach to governing — suggest he won’t be willing to deal with the problem.

Instead, I expect Trump to try to deal with rising interest costs a different way — by pressuring the Federal Reserve to lower interest rates.

Monetary interference and inflation

In theory, the Fed is supposed to be independent — it’s supposed to manage interest rates in order to strike a balance between high employment and low inflation. This means that when inflation rises, the Fed is supposed to do the dirty, thankless job of raising interest rates to fight it. Raising interest rates can cause a lot of short-term economic pain — for example, when Paul Volcker raised rates in the early 1980s, bringing inflation down at the cost of two painful but short-lived recessions. In other words, it’s the Fed’s job to be “bad cop” in the economy, and we give it a degree of autonomy in order to insulate it from the inevitable political backlash when hard choices are needed.

During his first term in office, Donald Trump repeatedly attacked the Fed, demanding that the Fed cut interest rates even more from their already low levels. This made many people feel that Trump was trying to compromise the Fed’s independence — applying political pressure on them for his own short-term political benefit.

Now, Trump’s allies are preparing an even more aggressive attack on Fed independence:

Donald Trump’s allies are quietly drafting proposals that would attempt to erode the Federal Reserve’s independence if the former president wins a second term, in the midst of a deepening divide among his advisers over how aggressively to challenge the central bank’s authority.

Former Trump administration officials and other supporters of the presumptive GOP nominee have in recent months discussed a range of proposals, from incremental policy changes to a long-shot assertion that the president himself should play a role in setting interest rates…

The group of Trump allies argues that he should be consulted on interest-rate decisions, and the draft document recommends subjecting Fed regulations to White House review and more forcefully using the Treasury Department as a check on the central bank. The group also contends that Trump, if he returns to the White House, would have the authority to oust Jerome Powell as Fed chair before his four-year term ends in 2026, the people familiar with the matter said[.]

In fact, Trump seems to love nothing more than feuding with, and establishing dominance over, American institutions; this is simply one more example.

Forcing the Fed to lower interest rates, even in the face of high-ish inflation, would help Trump keep employment high for the duration of his term. It would also push down the government’s interest costs, delaying the need for austerity. But the cost of those low interest rates would be higher inflation.

And as U.S. businesses, investors, and households realized that the Fed had been permanently compromised and politicized, inflation expectations would likely rise, canceling out the hard work that Volcker and his successors did to convince Americans that the Fed is inherently hawkish.

A combination of tariffs, high and rising deficits, and monetary interference could push inflation back to 1970s levels. Larry Summers, who correctly predicted the inflation of 2021, is right to worry:

Summers sees the same danger. “It is difficult to predict the timing and the precise dynamics,” he told me, “but it is hard to imagine a policy package more likely to create stagflation” than measures that directly raise prices (through tariffs), undermine competition, enlarge deficits, and excessively expand the money supply. “There is a real risk during a Trump presidency that we would again see mortgage rates above 10 percent as inflation expectations rose and long-term interest rates increased,” he predicted.

In Trump’s first term, he got lucky. Underlying inflationary pressures in the U.S. were still fairly weak, deficits crept up but stayed under control, Trump’s early tariffs had only a minor impact, and the Fed managed to resist Trump’s initial attack on its independence. In a second term, he might get even luckier, but I wouldn’t bet the farm on it.

And then there’s the outside chance that a second Trump term could usher in not just painful and persistent inflation, but an actual economic catastrophe.

Could Trump cause hyperinflation?

No one really knows what causes some countries to explode into very high levels of inflation. But economists have a guess. Basically, the idea is that when the government becomes committed to running big permanent deficits, and the central bank becomes committed to permanently supporting that borrowing with money creation, everyone basically abandons the country’s currency and its value collapses.

Some people think this only happens when countries lose wars or have some other kind of geopolitical instability. But in many hyperinflations in developing countries, there’s no war or revolution involved — instead, the combination of infinite deficits and infinite deficit-supporting money creation is due to a country’s own internal politics. In practice, this usually means that a country gets a populist leader who is committed to staying in power by handing out fiscal goodies to supporters and/or cronies, and who manages to force the monetary authority to support this strategy.

Could this pattern happen with Trump? It’s not likely. America is such a big rich economy, and the dollar is such an important currency, that it would take a heck of a lot of macroeconomic meddling in order to turn it into Argentina or Venezuela. But it’s not entirely out of the question, either. And the consequences of hyperinflation are so dire — Venezuelans were literally reduced to premodern living conditions in the 2010s — that it’s worth worrying about even if the chance is small.

Now, this might sound silly to some people who lived through Trump’s first term. There was no inflation under Trump the first time, why would we expect super-high inflation if Trump came back to power? But it’s worth noting that in most episodes of hyperinflation, it takes a number of years under the fiscally irresponsible ruling regime for inflation to explode. Things look OK for a while, and then bam.

For example, take Hugo Chavez and his successor, Nicolas Maduro. Chavez became President of Venezuela in 2002, and died in 2013. It’s pretty clear, in hindsight, that it was Chavez’ failed economic policies — continued by Maduro — that eventually resulted in Venezuela’s disastrous hyperinflation. But Venezuelan inflation looked like it was more or less under control until just before Chavez’ death!

Source: BBC

Or take Turkey’s President Recep Tayyip Erdogan, a populist leader who has been in office since 2014 and was prime minister for eleven years before that. Erdogan’s policy of constantly forcing the central bank to lower interest rates caused the currency to collapse and inflation to go to over 60% — not technically hyperinflation, but more than six times as high as U.S. inflation in 2021-22. Economic growth halted for a few years, and only a timely reversal of the low-interest-rate policy in 2023 managed to stabilize the situation.

But before 2018, Turkey had had comparatively low and stable inflation since 2004! It was four years into Erdogan’s term as president, and more than a decade since he became prime minister, before his policies made inflation explode.

This is what I worry about most when it comes to Trump and inflation. It’s possible that the stable, tranquil macroeconomic situation during Trump’s first term will convince people that Trump is a responsible steward of the macroeconomy, giving him political cover to engage in macroeconomic arson in a second term. Like Chavez and Erdogan — other populist leaders who feuded with their own country’s institutions — Trump might exert a corrosive effect on American macroeconomics whose true damage isn’t obvious until it’s too late.

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