Last week, I made a case for why I felt the Fed should cut the Fed Funds rate by 50 basis points this week. At the time, Fed Funds futures strongly suggested that the first cut would only be 25 basis points. By this weekend, the odds had shifted to 50-50. Inflation reports this past week continued to confirm that inflation is fast approaching the Fed’s 2% target. That shifts the focus to maintaining economic growth and a strong labor market. The stock market has rallied to within a whisker of its all-time high suggesting a belief that a soft landing is probable. But the bond market says otherwise. 10-year Treasury yields have shrunk to 3.65% from 3.90% at the start of September. The 2-10 year yield curve is no longer inverted. The futures markets are pricing in as many as 10 rate cuts by the end of 2025. That isn’t consistent with the notion of a solid economy and a soft landing.
Both markets can’t be right.
The Fed has to see this. Is the primary risk that inflation is going to reaccelerate over the next 12 months or is it that the economy might sink into recession if the Fed maintains a restrictive monetary policy for too long? To me, the answer is obvious. There are absolutely no signs that inflation is set to reignite anytime soon. There are some who fear a 50-basis point cut would be received by markets as a panic move. Hogwash! Rather, it would signal to me that the Fed is doing its job trying to stay in front of signals that suggest the possibility of a recession in the months ahead. A 50-basis point rate cut in September, followed by two 25-basis point cuts in November and December would give just enough lift and hope to raise the odds of a soft landing. A 50-basis point cut would be a bold move, not a sign of panic.
I want to shift gears and delve into political messaging that is coming from both sides of the campaign. Let me start with the Harris approach. Virtually every sentence that relates to the economy from Ms. Harris talks about improving life for the middle class. So, let me start there. Just how can we define the “middle class”? For one, it’s above the poverty level. For a family of 4, that is about $25,000 in annual income or below. We also know, in round numbers, that the median family income is close to $75,000. There are various definitions of middle class. Most bracket it somewhere above the poverty level up to twice the median income level. President Biden seems to have widened that definition, since whenever he talks taxes, he excludes talking of any tax increases for families earning less than $400,000.
If I put all this together, we have five economic classes in this country.
1. Poverty – Those earning less than $25,000 per year
2. Lower Middle Class – Earning $25,000-$75,000
3. Mid Middle Class – Those earning $75,000-$150,000
4. Upper Middle Class – Those earning $150,000-$400,000
5. Upper Class – The millionaires and billionaires earning more than $400,000 per year.
25% of our population is at or below the poverty level. Less than 2% earn more than $400,000 per year. Thus, when Biden or Harris talks about helping the middle class, they are saying to 70-75% of the population, the government will provide more benefits without charging them more. Those benefits could be child care tax credits, student loan forgiveness, tax breaks for small business or home buyers or whatever. All this without having them pay more money.
You and I can pick this message apart, but it resonates to those within the middle classes, as defined. It will resonate for those receiving direct benefits.
Now let’s look at the Trump plan. Again, I am just talking economics. He wants to cut taxes for everyone, hold down spending increases using the Musk efficiency machine, and pay for it all by raising tariffs. Sounds good at first blush. I’m not paying tariffs because I’m not importing anything, and who doesn’t like the idea of paying less in taxes? But here’s the rub. About 40% of Americans or those earning roughly $50,000 or less don’t pay Federal income taxes. So, they get no benefit from any tax cut. And while few of us pay tariffs directly, companies that do are likely to pass the increase along to consumers.
Neither the Democrat nor Republican plans pay for all the benefits they promise. Furthermore, any changes in the tax code require Congressional approval, something that will be difficult to achieve in a divided Congress. Note how little the Republicans have been able to do this past year with a slim majority. The Constitution requires tax legislation to originate in the House. On top of that many of the Trump cuts initiated in 2017 expire at the end of 2025. Many of those expiring cuts will impact the middle class.
The bottom line is this. As one might expect, the Democratic economic agenda speaks to the 98% earning less than $400,000 per year while the Republican agenda speaks to the 60% that pay at least some Federal income tax. No wonder the biases toward Democrats for those earning less and toward Republicans for those earning more. While neither side has a plan to pay for the goodies they promise, thus suggesting a massive further increase in deficits and borrowings, putting the promises into legislative packages is going to be extremely difficult.
Don’t expect either side to fill in the blanks before the election. Voters like to hear all the goodies being promised. They don’t want to hear how they are going to be paid for unless, of course, if they are told the top 2% will pay for everything.
When reality sets in next year, it’s going to be a very tough fight. In normal years, you might expect gridlock with nothing getting done. But that won’t be true in 2025 because allowing the Trump tax cuts to expire will be a de facto tax increase for many including the 70-75% sitting in the middle class, which are promised no tax increases by the Democrats. That means a lot of horse trading. Legislators from high tax states, led by current Senate Majority Leader Chuck Schumer, will want the state and local tax deduction increased. That won’t come cheaply. Kamala Harris is from California and many of her supporters come from Silicon Valley. Higher capital gains taxes or worse, taxing unrealized capital gains, would be a catastrophe to them. There are two sides to the clean energy credits. And so on. Simply said, there is going to have to be some sort of compromise and it is going to have to be scored to be as close to revenue neutral as possible. Debt and deficits are an abstract concept to most voters. But when annual interest costs, which now exceed defense spending, start to exceed the money spent on Social Security or Medicare, it will start to matter.
Predicting what a final tax/spending package might look like is a fool’s errand today. Too many moving parts. And until we know who controls the House and Senate, we won’t know who the conductors will be.
But the likelihood is that most of the promises won’t be fulfilled, at least not to their full extent. Trump’s 10% tariffs have now evolved into 20% tariffs. And that ignores retaliatory tariffs against American exports. As we have seen during the Biden administration, courts have squashed some of the giveaways such as student loan forgiveness. Thus, what is likely is that spending won’t reach the extremes promised and taxes won’t change as much as suggested. Of course, the devil is in the details and those are likely to change often between now and final passage later in 2025.
That won’t stop the promises. Exempting overtime pay from taxes, for instance, might be the suggestion du jour, but it will be dead on arrival next year when reality takes over. The good news is that the nonsense that moves to the front page every day will slow markedly after November 5.
There is an election on November 5 and a two-day FOMC meeting that concludes November 7. Hopefully, a lot of uncertainties will be cleared up by then, leading to a brighter outlook for equity investors going into year end.
Today, Amy Poehler is 53. Magician David Copperfield is 68.
James M. Meyer, CFA 610-260-2220