Donald Trump is a threat to America’s economic growth
The US economy is sustained by massive investments in artificial intelligence and spending by high-income households. But war in the Middle East poses a growing threat to the underlying vulnerabilities of the Middle East.
U.S. Commerce Department data late last week showed the economy grew at an annual rate of 2 percent in the March quarter, slightly below expectations for growth of 2.2 to 2.3 percent.
But more than half of this relatively modest growth came from business spending, reflecting the massive spending of AI companies. The largest tech companies, namely “hyperscalers” such as Amazon, Microsoft and Google, are expected to invest around US$750 billion ($1.04 trillion) in AI and its infrastructure this year, Meta said.
Consumer spending remained steady – personal consumption expenditure rose 1.6 percent in the quarter – but this was largely driven by higher-income families benefiting from the wealth effects of a booming stock market.
Research released Friday by the Federal Reserve Bank of New York showed that spending by high-income households has increased by 7.6 percent in cumulative real terms since the end of the pandemic. Spending by low-income households increased by just over 1 percent.
This is a “K-shaped” economy where middle- and low-income households benefit from their surplus savings; The U.S. savings rate is at its lowest level since late 2022 during the worst of the post-pandemic global supply chain shocks.
The period covered by last week’s data, which is often subject to large-scale revisions, covers just one month of the war in Iran, which sent oil prices soaring worldwide, followed by gasoline and diesel prices.
Before the US and Israel attacked Iran, and before Iran’s retaliation closed the Strait of Hormuz and damaged regional energy infrastructure, causing global oil prices to rise above US$100 per barrel, the average US gasoline price was less than US$3 per gallon and diesel was selling for around US$3 per gallon. Currently, the average price of gasoline is $4.45 per gallon and diesel is selling for $5.64 per gallon.
This steep increase in energy costs will lead to an inflation rate that is already heading in the wrong direction.
Last week’s personal consumption expenditures (PCE) data, the Federal Reserve Board’s most trusted measure of inflation, showed that the PCE index increased by 0.7 percent in March compared to February and 3.5 percent compared to the previous year. The monthly increase was the largest since 2022.
“Core” prices, excluding energy and food prices, increased by 3.2 percent compared to a year ago. The Fed’s inflation target is 2 percent.
The pressure on the inflation rate even before the full effects of the war in the Middle East became apparent explains why there was an unusual presence of dissenters at last week’s Fed Open Market Committee meeting.
Three members of the committee that determines US monetary policy opposed the inclusion of a statement in the Fed’s post-meeting statement that implied easing bias; because they believed that the Fed’s next interest rate move could be either a reduction or an increase, depending on the duration of the war.
The war may be prolonged due to the inability of the United States and Iran to negotiate an acceptable exit from hostilities.
The longer this situation persists and energy prices remain high, the greater the risk that high inflation will become embedded in economies and inflation expectations, and the greater the likelihood that the US will raise interest rates to control the inflation rate, as the Federal Reserve is being forced to do, regardless of what Donald Trump wants from incoming Fed chairman Kevin Warsh.
But even excluding the initial effects of the war, there was a pre-existing threat of inflation, with core inflation rising steadily in recent months.
This may have something to do with Trump’s tariffs, which added more than $175 billion to the cost of goods for US companies and consumers last year (there’s inevitably a lot to do).
Although the majority of these tariffs were declared illegal by the U.S. Supreme Court, the Trump administration preserved many of them using a different (and also allegedly illegal) title while working on a long-term alternative.
Prices of sectors exposed to tariffs increased sharply in the March quarter. Prices of clothing and shoes increased by 6.8 percent, household goods by 5.9 percent and recreational vehicles and goods by more than 20 percent.
The impact of the tariffs essentially offset the benefits households received from the massive tax cuts in Trump’s One Big Good Bill last year, which were expected to provide a greater boost to growth.
They also provide protection against ongoing price increases for domestic producers due to reduced competition from imports; This means it could have a lasting impact on inflation rather than being a one-off shock to the inflation rate.
Prolonging the war in the Middle East will fuel the embers of the trade war and force the Fed’s hand.
It has already seen bond yields determine how much businesses and consumers will pay for increased financing.
Before the attacks on Iran began, the yield on two-year bonds was below 3.4 percent. Now they are around 3.9 percent. The yield on 10-year bonds was slightly above 3.9 percent. They are currently hovering around 4.4 percent.
If the inflation rate continues to rise, yields should also rise, which will have negative effects on economic growth.
Investing in AI to sustain its gains and the stock market’s dependence on AI (and stock investors’ blatant disregard for the war’s relevance to their own interests) are other points of potential economic vulnerability.
Prolonging the war in the Middle East will fuel the embers of the trade war and force the Fed’s hand.
The pace of growth in AI investment (hyperscalers alone spent less than $400 billion on AI last year, but could reach $1 trillion next year) is straining the ability of markets to provide the necessary equity and debt.
Any disruption in meeting the markets’ optimistic expectations of future business returns from the sector could cause a shocking jolt.
Higher inflation and interest rates would also be unhelpful; As the cost of AI data centers increases, the discount rates applied to future cash flows and earnings, and thus the stock market valuations of companies, will also increase.
Any wobble in the stock market would also be reflected in consumer spending, which drives nearly two-thirds of U.S. economic growth; A rise in interest rates would increase the cost of servicing the US government debt, which exceeds $39 trillion, and heighten existing concerns about the sustainability of government finances.
So the outlook for the U.S. economy (and Republicans’ expectations for this year’s midterm elections) rests on a continuation of the boom in AI investment, a stock market that continues to increase the wealth of high-income households, and a relatively quick end to the war in Iran before inflation driven by energy prices stabilizes.
All three pillars of modest US growth have some potential vulnerabilities; But how and when the war and its threat to inflation and the stock market will end is clearly within Donald Trump’s control… if he can implement it without the complete capitulation that Iran seems unwilling to provide.
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Stephen Bartholomeusz is one of Australia’s most respected business journalists. He was most recently co-founder and deputy editor of the Business Spectator website and associate editor and senior columnist at The Australian.Connect via email.
