Attention will once again return to the intertwined relationship between the US Federal Reserve and economic policies with the election of Donald Trump for a second presidential term in 2024.
This relationship was not always easy, as Trump repeatedly criticized the Federal Reserve during his first term.
As the US economy enters a critical phase of recovery after a major inflation crisis, the impact of new financial policies and economic reforms may pose a profound challenge to monetary policy makers at the Federal Reserve.
Interest rates… between stability and risks
In 2023, the Federal Reserve raised interest rates to 5.5%, the highest level in more than two decades, in response to inflation that reached 9.1% in mid-2022.
However, with inflation gradually declining to 3.2% by the end of 2024, the reserve began reducing interest twice to range between 4.25% and 4.50%.
This trend reflects a shift towards stimulating the economy, amid signs of slowing growth. However, Trump announced immediately after taking office that reducing taxes and increasing public spending would be the main axes of his economic policy, which raised fears of a return to inflationary pressures.
Although the Federal Reserve expects to reduce interest rates by an additional 50 basis points during 2025, adopting expansionary financial policies may change this scenario.
According to Diane Swonk, chief economist at KPMG, aggressive fiscal policies could “constrain the Federal Reserve” and put it in a position that forces it to raise rates again to curb inflation.
Fiscal policies and their impact on the macroeconomy
- Cut taxes and increase the deficit
One of Trump’s most prominent promises is to extend the Tax Cuts and Jobs Act of 2017, which had a significant impact on reducing taxes on individuals and businesses.
This law, despite stimulating economic growth by 0.4% annually, led to an increase in the federal deficit by $1.5 trillion over 10 years. If these cuts are extended, they may enhance liquidity in the markets, but they will add new inflationary pressures that may push the reserve to adopt more stringent policies.
- Tariffs and a renewed trade war
As part of the “America First” policy, Trump plans to re-impose customs tariffs of up to 25% on Chinese imports.
This step may increase production costs for American companies and raise prices for consumers, leading to an increase in inflation by about 0.5%-0.8% during the first year of its implementation, according to recent assessments conducted by Bloomberg.
With the expected impact of tariffs on global markets, emerging economies may face additional challenges represented by a decline in capital flows and a deterioration in the value of local currencies, as happened previously with Türkiye and Argentina.
- Expansion of fossil fuels
In the energy sector, Trump is looking to boost fossil fuel production, which could cut energy costs by 10% and stimulate industrial production.
But according to Mark Zandi, chief economist at Moody’s Analytics, these policies, despite achieving short-term economic growth, may lead to unsustainability in the long term.
Global and local repercussions
The potential effects of US policies are not limited to the interior, but rather extend to global economies, especially with global central banks relying on Federal Reserve policies as a standard for currency stability.
The European Central Bank, for example, raised interest rates to 4.5% in 2024, mimicking the American trend.
With the Fed reducing interest rates, the world may witness greater stability in financial markets.
On the other hand, the expected rise in the dollar as a result of the influx of foreign capital may exacerbate the US trade deficit and weaken export competitiveness.
Repeated protectionist trade policies may also lead to escalating tensions with trading partners such as Canada and the European Union, further complicating the economic landscape.
Challenges facing American families and economic sectors
- Housing market and mortgages
Despite the low interest rates, Trump’s policies may lead to a rise in long-term government bond yields, which are the primary criterion for determining mortgage rates.
This may keep borrowing costs high and weaken demand for homes, adding to the challenges of the housing market.
- Consumer spending and work
Consumer spending – which represents 68% of US gross domestic product – may witness limited growth in light of rising tariffs and declining purchasing power.
At the same time, anti-immigration policies may reduce labor supply and push up wages, making inflation more difficult to manage.
Future scenarios
- Growth scenario supported by fiscal stimulus
In this scenario, Trump’s expansionary policies such as extending tax cuts and increasing infrastructure spending lead to a rapid economic recovery and strong growth, but are accompanied by inflation and rising fiscal deficits, threatening the long-term sustainability of this growth.
- High inflation scenario
As a result of aggressive fiscal and customs policies, the economy is witnessing a sharp inflationary wave that affects purchasing power and increases the cost of production, forcing the Federal Reserve to tighten monetary policy, which may lead to serious local and global economic turmoil.
- Relative stability scenario
In this most optimistic scenario, the US administration succeeds in coordinating its financial policies with the Federal Reserve, which leads to achieving sustainable economic growth with moderate inflation rates, while stabilizing global financial markets.
- Economic recession scenario
If uncontrolled financial policies lead to pressure on the Federal Reserve to raise interest rates significantly, the US economy will enter a recession as a result of slowing economic activity and rising unemployment, which will harm small businesses and emerging markets.
- Geopolitical tensions scenario
With the escalation of trade tensions resulting from Trump’s protectionist policies, global supply chains are affected and American exports are weakened due to the rise in the dollar, leading to disruptions in global trade and increased volatility in financial markets.
