The U.S. Chooses Stagflation

Policy choices over the past six weeks risk pushing a previously strong economy into a world of faster inflation and slower real growth.

Policy arbitrariness and volatility are already contributing to faster inflation and a deteriorating growth outlook in the U.S. While the damage could still be contained with a change in approach, or offset by other measures, the initial data suggest that the strong economy inherited by the new administration is being squeezed on both sides in ways that will worsen living standards for consumers and returns for investors.

The U.S. Government’s (Inadvertant?) War on Investment

Every business decision is a bet based on guesses about how the future will unfold. Big commitments—whether it is hiring a lot of workers, investing in research or physical capital, buying another company, or shifting resources to new product lines—require some combination of high confidence in the outlook and high potential rewards to compensate for the risk of being wrong. Many choices can be justified if the possible payoffs are deemed to be high enough, but risk and uncertainty are genuine impediments to hiring and capex. It is not a coincidence that the richest societies in the world, excepting a few oil sheikdoms, are the places that make it easiest for businesses and individuals to make long-term plans without fear of arbitrary abuses (or predictable confiscation).

While every jurisdiction has room for improvement, the U.S. business environment has materially worsened in the past six weeks. Perhaps most striking is not just the actual changes that have been announced, but the volatility and uncertainty around those changes. Discriminatory tariffs on imports from Canada and Mexico are almost uniquely pointless acts of self-harm¹, for example, but discriminatory tariffs on Canada and Mexico that keep changing are worse. People can adapt to bad policies, but it is impossible to adapt when both the end state and even the direction of travel are unknowable. As Macbeth put it, “If it were done when ‘tis done, then ‘twere well/It were done quickly”. Instead, the business environment changes on a daily or even hourly basis. In this world, the most rational choice is to hoard and wait.

Defenders of the administration’s chaotic approach sometimes say that it is a complex negotiating strategy to secure a better “deal”, although rarely with specifics about what is supposed to be achieved. But even if there were a “deal” to resolve the “conflict” with Canada and Mexico, it is unclear why any agreement would be worth anything, given that the U.S. president instigating the chaos is the same one who had negotiated a trade treaty with Canada and Mexico that entered into force less than five years ago. What would stop this administation from doing it all over again?

More importantly, there is no reason for executives observing these events to think that this pattern will not be extended to other areas over the next four years—or longer. The costs of this constant policy volatility will cumulate over time, raising the cost of capital and discouraging hiring and investment. Even if the arbitrariness suddenly stops, which seems unlikely, the knowledge that it could restart at any moment will be a persistent drag on business activity.

And while the regulators and legal authorities have not yet been deployed against the administration’s perceived domestic enemies, there is no guarantee that this will persist. Many business executives, particularly those with heavy regulatory exposure and/or large government contracts, have been trying to manage this caprice with flattery, misleading pledges about job creation and capex, and quasi-bribes. Even if their efforts “work”, in a narrow sense, there will be long-term costs for the broader economy as risk-takers adapt to a world where they must constantly worry about being exploited.

Since the election, U.S. “Economic Policy Uncertainty” estimated by the economists Scott R. Baker, Nick Bloom, and Steve Davis from news articles, professional forecasters’ disagreements, and other sources has soared to the highest level ever recorded outside of the pandemic. That is particularly striking because their measure often captures external sources of uncertainty, such as the first Gulf War, the 9/11 attacks, and the financial crisis. Yet none of those was perceived to be as disruptive as the current administration’s choices on a monthly basis². Moreover, this is evident in the subcomponents they publish excluding trade policy. A simple average of the z-scores of their indices covering taxes, spending, entitlements, healthcare, and regulation is also at its highest level outside of the pandemic.³

All of this could have been predicted—and was, by many people. Many business leaders and investors, however, ignored the full implications until the past few weeks. The speed of the response means that we do not yet have much data to quantify the impact of all this, but there are some clues. None of them are encouraging.

Investment Down, Prices Up

Five of the regional Federal Reserve Banks—New York, Philadelphia, Kansas City, Dallas, and Richmond⁴—have been running detailed surveys of manufacturers in their district for at least two decades. They ask questions on everything from employment to capital spending plans to inventories and more. The latest surveys, which are from early-to-mid February, and therefore do not even capture the latest spikes in policy volatility, are painting a consistent and unwelcome picture: less investment and higher prices.