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US contemplates tax policy as the BoE licks wounds

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The media had much fun last week trying to determine the most notable events from the first 100 days of President Trump’s reign. The Donald did not seem to come out of it too well, although a good bombing well away from home will always provoke a favourable reaction if more domestic policies have run into the quicksand.
 
One aspect that got overlooked in the bigger scheme of things was the latest GDP figures for the past quarter. These showed the US economy growing, on an annualised basis, at just 0.7% which was well below the median forecast of 1.1%. The culprit was consumer spending which fell to a paltry 0.3%, a low not seen since 2009. The markets were remarkably untroubled by these figures, with both the equities and bond markets showing little reaction as there is considerable evidence that the next quarter will show a much improved result. This optimism is largely generated by consumer confidence surveys.
 
The figures certainly did little to dent confidence that the Fed will hike interest rates again at its meeting next month. The odds of another rate hike are running at about 71%, with most market commentators regarding it as a done deal as long as the non-farm payroll figures rebound from last month’s very depressed level.
 
The Donald has, of course, promised to boost economic growth to 4% per year - not a figure that is given much credence, but he decided to make a start last week by announcing that he was looking to reduce the corporate tax rate from 35% to 15% and the individual tax rate from 40% to 33%. Just to add a bit of further excitement, he proposed a one-off tax cut to US companies if they repatriated some USD2tn currently held in overseas subsidiaries. There were no signs of any offset to this munificence through tax raising or even cost cutting. They were presented as a proposal rather than as definitive policies, and are likely to provoke problems even for a Republican Congress committed to a balanced budget, to say nothing of being able to put a new ceiling in place for the US deficit.
 
However, there may be a loophole that the President appears to be warming up Congress to accept. The rules under which the federal debt operates is that Congress can approve increases in debt (subject to a minimum majority) as long as the additional debt is recouped within 10 years. Taken on a standard evaluation methodology, the proposed cuts amount to a tax giveaway of anything up to USD7tn. Step forward Arthur Laffer, once Ronald Reagan’s adviser. Laffer’s argument is that the financial impact of Trump’s proposals should be calculated through ‘dynamic scoring’ which claims to be able to calculate the enhanced tax revenues that will be generated by these expansive economic policies. According to Steve Munchin, the newly appointed Treasury secretary, the additional revenue under this method of calculation will cause the deficit to disappear. 
 
The Trump administration may have some difficulty in persuading Congress to accept the Laffer methodology. Past history does not do much other than discredit it. Presidents George W Bush and Barack Obama both tried using tax cuts to boost the economy – unsuccessfully in both cases. Somewhat ironically, Presidents Bush (the elder) and Clinton both raised taxation and were rewarded with higher growth levels. It will be interesting to see whether this develops into a realistic debate. If Congress is persuaded into signing off on a policy of such fiscal laxity, it is not difficult to imagine the Fed’s reaction. The return to normalisation is likely to peak at a much higher level than currently anticipated if fiscal restraint is almost completely absent.
 
The UK also announced the initial estimate for the first quarter GDP. This came in at 0.3% for the quarter, probably a fraction below the median estimate. It was, however, only half the 0.6% level that the Bank of England had forecast only about a month ago. While the Bank has a reputation for normally underestimating changes in economic data, it had obviously got bored with its dire post-Brexit forecasts but chose the wrong month in which to swing in the other direction. The press took its normal swipe at the forecasting ability of the Bank of England’s economics department, but it must now be getting to a state where its forecasting ability is so awful that Mark Carney will be forced into a review of its effectiveness. Fortunately its output does not have any impact on monetary policy, which is to maintain rates at minimal levels at all costs.
 
The main cost at the moment is, of course, inflation and the impact of the depreciated pound. Unlike the US, there is no confidence in a consumer-driven revival of consumer spending. As the boss of Next, Lord Wolfson, has pointed out, this will only get worse in sectors like clothing when hedging that was put into place to control the cost of imported goods starts to run out. Unfortunately, the situation facing the UK economy is pretty well the opposite of that facing the US. As earnings remain at lowish levels and costs continue their inflationary rise, spending will be further reduced. Furthermore, any surplus cash is more likely to find its way into replenishing savings from their current low levels. It is very difficult to see how this position is going to reverse in the near future – indeed it is likely to get worse. With the Conservatives trying hard to get out of their economically idiotic commitment at the last election to the triple lock on increasing taxation, the thought that they, or any other party, announcing a Trump-esque taxation solution is, thankfully, remote.
 
Domestic economic releases this week are dominated by the CIPS surveys, with the manufacturing data out today, construction sector out tomorrow and the all-important services sector out on Wednesday. The median forecasts had seen them all expected to fall back slightly from last month’s levels. Pleasingly, the manufacturing figures confounded forecasters by coming out at 57.3 against 54.2 last month, showing that fears that the boost provided by the depreciating pound for exporters was starting to fade looks to have been misplaced. The latest household borrowing figures are released on Thursday and are expected to show a reduction in consumer credit lending as well as a fall in mortgage approvals. There are two other releases of note, with the eurozone’s first-quarter GDP figures being released tomorrow and forecast to show a rise of 0.5%, and the key US non-farm payroll figures being released on Friday and expected to rise back up to just short of the 200,000 mark. The markets are not likely to make much progress in either direction until the non-farm payroll figures are out of the way.

All views expressed here are the author’s own and are based on information and data available at the time of writing.

 

 

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