The U.S. economy is in very good shape. Real GDP—or inflation-adjusted output—has been growing at a 2 ½ to 3% pace. The unemployment rate is 4%—consistent with full employment—and core inflation has settled around 3%, down significantly from the COVID-induced surge of 9%.
Financial markets reflect this solid performance. The S&P advanced by around 25% in 2023 and 2024 and has risen at about the same annual pace since the November election. Long-term interest rates have moved up due to stronger-than-expected economic growth, higher-than-expected inflation, the persistence of large budget deficits and the implication that the Federal Reserve will not reduce rates as much as had been expected. The dollar has strengthened significantly, mostly reflecting the direct and indirect effects of the massive outperformance of the U.S. economy.
A Surge in Immigration Allowed Wage Growth to Moderate in a Tight Labor Market
Markets have also adjusted to the notion that the economy can handle higher interest rates, and that core inflation is unlikely to get down the Fed’s target of 2% anytime soon. After cutting its target interest rate by a whole percentage point in the last four months of 2024, the Fed has adopted a wait-and-see posture regarding further easing.
The U.S. experienced a prolonged period of unusually low inflation and interest rates following the financial crisis. The Federal funds rate averaged less than 1%, and 10-year U.S. Treasury yields ranged between 1.5-3%. Persistently low inflation reflected free trade and the productivity-enhancing benefits of the internet. Those days are over. We are now in an environment of increasing tariffs and a push to produce in home countries. Meanwhile, the Covid experience has induced firms to take risk into account instead of focusing solely on cost in determining where to produce and source inputs. They have diversified their supply chains and are maintaining higher inventories.
A recession seems unlikely anytime soon. There is no evidence of the excess that usually precedes recessions. Both household and business balance sheets are healthy and don’t appear over-extended in terms of debt burdens or excessive risk-taking.
The big question is how President Trump’s economic policies will pan out. His proposals on tariffs and immigration pose a risk to continued strength of the U.S. economy, while his commitment to deregulation could provide an additional boost.
Tariffs Raise Revenue but Increase Prices and Reduce Output
Significantly higher tariffs on imports from key trading partners would undermine international trade, which boosts U.S. economic growth and exerts downward pressure on inflation. Free—or unfettered—trade is inherently mutually beneficial since no one forces people or countries to trade. When it comes to trade between countries, it’s more complicated and nuanced since some sectors of the economy are made worse off and others better. Empirical studies reveal a net positive effect, but it doesn’t always feel that way.
Global trade took off in the 1980s, reflecting the increasing recognition of its benefits and the opening of the Communist bloc. The U.S. became a major importer of manufactured goods and an exporter of technology. Manufacturing employment in the U.S. fell sharply and many towns and cities that hosted those firms were hollowed out. On the plus side, hundreds of millions of Americans buy all kinds of goods for much lower prices than they otherwise could. This allows them to spend more money on other things like cell phone and streaming services, travel and going out to restaurants and entertainment venues, which provides additional jobs in those and many different industries. But that benefit is much less evident and visceral than losing manufacturing jobs and hollowing out of cities.
One of the underlying reasons for the U.S. economy’s persistent strength has been its ability to absorb social upheavals that accompany technological and economic progress. Over 90% of Americans were farmers at the time of the Revolution, but if that were the case today, the U.S. would be a poor country. Millions of people left for cities instead of spending their lives on farms during the Industrial Revolution, and the U.S. became an industrial giant. While that is no longer the case, the U.S. now dominates the technology sector.
There’s another, less obvious benefit of international trade for the U.S. It has historically had a lower saving rate than most other countries but maintains a very high level of investment, especially in technology. That’s because the trade deficit is matched by a surplus in the capital account: foreigners buy much more U.S. assets than Americans buy of theirs. Foreign ownership of U.S. assets provides the U.S .with a huge advantage. When foreigners buy U.S. Treasuries, stocks, and corporate and mortgage securities, the supply of loanable funds in the U.S. increases, lowering interest rates and providing more funds for domestic investment. This allows Americans to save less and spend more—boosting U.S. economic growth—while enjoying the benefits of investment.
President Trump has argued for 60% tariffs on Chinese goods and 25% on imports from Mexico and Canada. These are the U.S.’s biggest trading partners, accounting for more than half of all merchandise imports. The President has also proposed 10-20% tariffs on all other imports. The current average tariff on all U.S. merchandise imports is 2.3%.
If all were enacted, this would represent the biggest increase in U.S. tariffs since the Smoot-Hawley Act of 1930, which was legislated with the goal of protecting American farmers and other industries from foreign competition. It ended up provoking massive retaliation by other countries that resulted in a trade war, reduced global trade by some 60%, and significantly worsened the severity of the Great Depression in the U.S. and around the world.
Many of these tariff proposals may not be enacted and instead used to extract concessions from U.S. trading partners. The President has already delayed the tariffs on Canada and Mexico with the prospect of those countries delivering on illegal border crossings and drug trafficking. In addition, the sharp decline in the stock market when the tariffs were first announced may act as a bulwark against further action.
Tariffs are charged as a percent of the price an importer pays a foreign seller. Much of the increased cost to importers is passed along through higher prices to consumers. In addition to these direct costs, tariffs also incite damaging retaliatory action by the countries on which the U.S. imposes tariffs.
President Trump raised tariffs in his first term and the U.S. economy and financial markets performed very well before Covid hit. But those tariffs were much more narrowly focused than what he has proposed this time around. And a huge tax cut was enacted in 2017—before the tariffs were imposed—that gave the U.S. economy momentum and more than offset the negative effects.
While the U.S. economy held up, the tariffs imposed during President Trump’s first term caused a recession in the manufacturing sector instead of protecting it as intended. Employment in manufacturing fell by 48,000 in 2019, following retaliatory measures by China and the EU, which imposed tariffs on U.S. exports of steel, aluminum, pork, soybeans, whiskey, blue jeans, and other items.
The tariffs did raise revenue, but even if all the proposed tariffs are carried out, they would be nowhere near enough to replace U.S. income taxes, as President Trump has suggested. Tariff revenue amounted to $77bn last fiscal year, or roughly 1.5% of federal tax revenue. A 60% tariff on all imports from China and a 10% across-the-board tariff on all other imported goods would generate some $450bn in revenue. While that would be a significant haul for the U.S. Treasury, it pales compared to the revenue raised by personal income and payroll taxes—$2.4 and $1.7 trillion, respectively.
Fiscal Policy Not Likely to Have a Major Impact
President Trump has also promised to cut both federal taxes and spending. The Tax Cuts and Jobs Act of 2017 lowered personal and corporate tax rates. Personal income taxes were reduced for all income brackets, and the statutory corporate tax rate was lowered from 35% to 21%.
The personal income tax cuts are scheduled to expire at the end of this year and the President has proposed extending them or making them permanent. He has also proposed additional tax cuts, such as:
• Eliminating taxes on Social Security benefits, tips and overtime pay
• Cutting the statutory corporate tax rate further to 20% overall and 15% for companies that produce their products in the U.S.
• Scrapping the $10,000 deduction limit on state and local taxes
A major difference between tariffs and fiscal policy is that both houses of Congress must pass spending and tax changes. While Republicans have majorities in both, they are notably thin, which should make new legislation difficult. By contrast, the President can effectively dictate tariffs.
Most, if not all, the extensions of the Trump tax cuts—which had broad Republican support—are likely to pass, even though the Congressional Budget Office estimated that the full extension would add $4.6 trillion to budget deficits over the next 10 years. But there are enough remaining Republican deficit hawks in Congress to suggest that prospects for any new tax cuts are limited.
Budget deficits averaged 1-3% of GDP in the years before the financial crisis, but soared to double digits following two recessions and the massive fiscal and monetary stimulus that followed. Deficits have shrunk since then but have remained over 6% of GDP the past couple of years, the most significant non-recession budget deficits since World War II. The outsized deficits have brought U.S. government debt to $35 trillion, an increase of over $25 trillion over the past 18 years. Interest payments on federal debt have also exploded, doubling to over $1 trillion and still growing.
President Trump has also created a new government agency run by Elon Musk called the Dept of Government Efficiency—or DOGE—that promises large spending cuts. It is unlikely that spending reductions will be enough to quell concerns about the high levels of U.S. government deficits and debt. Musk initially set a target of $2 trillion in spending cuts but more recently said a more realistic number is $1 trillion. Even that would be very difficult to achieve and would put only a dent in the growth of federal government debt anyway.
Discretionary spending—that is, spending not dictated by law—has become a relatively small component of overall federal spending and, at this point, doesn’t seem excessive. It is now around 6% of GDP, well below the 8% 50-year average, and amounts to only 26% of total government spending, down from over 60% in the 70s. Moreover, around half of discretionary spending is accounted for by defense appropriations. The wars in Ukraine and Israel have depleted U.S. weapons, and there is a need for restocking, making it difficult to reduce overall discretionary spending.
On the positive side, Elon Musk believes that he can apply new technology to government services that will require less workers. DOGE has already offered incentives for federal workers to quit, although legal obstacles to this effort may be difficult to overcome. Given the technological innovations behind such companies as Tesla, Space X, Starlink and Neuralink, there is reason to believe Musk can achieve success in this effort. That said, the stated goal is to cut 10% of the federal workforce and save around $100bn per year, a large amount of money but not compared to the $6.75 trillion that the U.S. government spent in fiscal year 2024.
Mandatory spending now accounts for two-thirds of the budget, 80% if you include interest payments, which are not required by law but are functionally mandatory. The total now amounts to over 17% of GDP compared with the 50-year average of 13%.
Social Security, Medicare, and veterans’ benefits account for the bulk of mandatory spending, and demographics are the main source of the increase. The aging of the U.S. population—reflecting the huge cohort of the baby boom generation that is now retiring, the increase in life expectancy, and our historically low birth rate—is the main reason for the increased spending on these programs.
Reduced Immigration Would Reduce Output and Increase Prices
A potential solution to this problem is more immigration. However, the political climate has moved in the opposite direction, and immigration to the U.S. has already begun to decline. President Biden signed an executive order last summer that has significantly reduced humanitarian entries into the U.S. President Trump has already signed a slew of executive orders that are intended to reduce both legal and illegal immigration as well as deport immigrants who are in the U.S. but do not have legal status. At this early stage, the effects have been limited to thousands of people, not enough to have an appreciable impact on the overall economy. But if it extends to hundreds of thousands or millions, it will damage output, employment, and inflation.
The U.S. needs immigration now more than ever. It increases our labor supply, boosting our supply of goods and services. Among the most critical challenges facing the U.S. today is its declining population growth, which is lower than at any point in its history. Immigration accounted for most of its now meager 0.4% population growth. The labor force has also grown less than 1% over the past year. Without immigration, the prime-age workforce (between the ages of 25 and 54) would have seen essentially no growth over the past 25 years, dramatically restricting the ability to grow the economy and staff key industries.
Demographics undermine the financial viability of vast social programs like Social Security and Medicare. These programs operate like Ponzi schemes: when the labor force grows faster than the retirement population, they tend to fund themselves. That changed beginning in 2021, and these programs under current law are expected to go bust by 2035.
There are basically 3 solutions: raise taxes, cut benefits, or open the door to more immigration.
The viability of Social Security and Medicare is not the only risk associated with less immigrants. They make up a large component of the U.S. population and workforce. In 2023, nearly 48 million immigrants lived in the U.S., accounting for over 14% of the population. Immigrants comprise an even bigger portion of our workforce: more than 19%.
U.S. economic data show that immigration has been a boon for the U.S. economy. It surged post-pandemic, adding 5 million workers between 2021 and 2024. That is why wage growth has moderated despite strong job growth and a very low unemployment rate.
Immigrants are a net benefit to the U.S. economy. A study by the CATO Institute in 2023 estimated that first-generation immigrants contributed an average of $16,207 per capita to the economy yet cost an average of just $11,361. Undocumented immigrants pay nearly $100 bn in federal, state, and local taxes per year, with more than a third going to payroll taxes that fund programs that illegal immigrants are barred from accessing.
Deregulation Can Boost Growth by Increasing Efficiency
There is little clarity on which regulations the Trump Administration will try to eliminate and whether it can succeed. Deregulation can boost growth and lower inflation by increasing the efficiency of the private sector. But it can also have damaging effects.
Government regulations are necessary. We need them to keep our food supply, cars, planes, pharmaceuticals, and workplaces safe and our environment cleaner. However, frustration with their sheer volume and scope is understandable. The Code of Federal Regulations has ballooned to more than 180,000 pages. Regulations affect almost everything produced in the economy, and in many circumstances, their complexity—especially when layered on top of state and local rules—can make it difficult for businesses to operate and for new and much-needed construction of infrastructure to be built.
President Trump has explicitly attacked government regulatory policy in at least three areas: electric vehicles, energy, and banking.
The President has already revoked Biden’s executive order that half of all vehicles sold in the U.S. should be electric by 2030. He also ordered the suspension of using unspent funds for EV charging stations, is reconsidering mandates for more stringent emissions rules, and wants to eliminate the $7,500 federal credit for EV purchases. These efforts will almost certainly be challenged, not only for environmental reasons. The carmakers supported Biden’s 50% mandate since they invested heavily in electric vehicle production.
President Trump has declared an “Energy Emergency”, and pledged to expand oil production, make the U.S. the dominant energy producer and achieve energy independence. However, the U.S. is already producing record amounts of oil and natural gas due to the shale boom and advancements in hydraulic fracking. It is now the biggest producer of oil and natural gas in the world by far and is energy independent. The U.S. has been a net exporter of natural gas since 2017 and a net exporter of oil and petroleum products since 2021. The only way to induce companies to produce more energy at this point is if prices rise.
Finally, bank deregulation is likely to be helpful for our banking system, financial markets and their customers. The Dodd-Frank bill passed after the financial crisis required banks to hold more capital and use less leverage to ensure their safety. It has largely succeeded, and banks are better capitalized than ever. However, their inventories of securities are much smaller due to the capital and risk requirements, making them less capable of quelling market disturbances. Some loosening of capital requirements in certain markets, like the repo market, would probably improve the liquidity of financial markets and reduce volatility.
The Trump Administration will likely be more friendly to bank mergers that should increase the efficiency of the banking system and allow small and mid-sized regional and community banks—who provide specialized services to many small firms and local customers—to thrive. Consolidation of the banking system has been going on for decades due to economies of scale. The U.S. still has more than 4500 banks, and more consolidation is necessary to attract capital to the smaller institutions that will allow them to continue to serve their communities.
