Iran’s Economic Shadow over the Midterm Elections | American Enterprise Institute
Two weeks ago, in his State of the Union address, President Trump painted a rosy economic picture. In his view, thanks to his policies, the economy was strong, growing, and entering into a golden age. He also boasted that wages were growing, inflation was falling, gasoline prices were declining, and the stock market was at a record high. In making those claims ahead of November’s midterm congressional elections, Trump seemed to be mindful of James Carville’s observation that when it came to elections, it was the economy, stupid.
One week later, Trump put those claims at risk by starting, together with Israel, a full-scale war on Iran. That war threatens to upend the international energy market which could prove to be a major headwind for the economy. Making it all more likely that the economy will be a major source of weakness for Trump in the midterm elections is the fact that Trump has chosen an economically inappropriate time to subject the economy to an energy price shock. Even before the war began, affordability was a major issue, the public finances were on an unsustainable path, foreigners were losing confidence in the United States, and stock market valuations were at lofty levels.
A key issue that won Trump a second term was his promise to bring down prices. Yet, one year into his term, while inflation might have stabilized, the price level has gone up by around three percent. The war now threatens to exacerbate the country’s affordability problem and create a significant headwind to the economy.
The most obvious way that the war will increase inflation and reduce economic growth will be at the gas pump. Mainstream estimates suggest that for every sustained $10 sustained increase in the international oil price, US inflation would increase by between 0.15 and 0.3 percentage points and would subtract between 0.1 and 0.2 percentage points from economic growth. Considering that the international oil price has already increased by more than 50 percent to its present level of around $100 a barrel, this means that if sustained, the current level of gas prices could add over one percentage point to inflation and subtract between 0.5 and 0.75 percentage points from economic growth.
Higher interest rates would be another way by which the war could exacerbate the affordability problem and constitute a major headwind to economic growth. This would seem to be especially the case, considering that the war is bound to aggravate an already troublesome public finance situation.
Even before the war began, the Congressional Budget Office estimated that the US budget deficit would remain in the vicinity of $2 trillion a year or some six percent of GDP as far as the eye could see. That in turn would take the public debt to GDP ratio to its highest level since the end of the Second World War. With the war now costing over $1 billion a day, it would seem that the defense budget will need to be increased by at least $50 billion to cover the cost of the four-to-five-week war that Trump is anticipating. In addition, the war might strengthen the case for Trump’s proposal to increase the defense budget by $500 billion over the next two years by heightening the risk of Chinese adventurism in Taiwan.
The combination of higher inflation and a widening budget deficit will make it difficult for the Federal Reserve to resume cutting interest rates. Worse yet, that combination might make investors reluctant to buy US government bonds at current yields for fear that the US might be on the road to higher long-term inflation. Should that occur, we could see a significant rise in the all-important 10-year US Treasury bond yield. It has to be of concern that the US Treasury market already seems to have lost its safe-haven status. In the recent episode of heightened market volatility, the 10-year Treasury yield has increased by 25 basis points to around 4.2 as investors seem to be losing confidence in the US as a reliable debtor nation.
A spike in long-dated government bond yields would add to Trump’s affordability problem by leading to higher mortgage rates and automobile loan rates. Such a spike might also be the trigger that causes a sharp decline in equity prices from their currently still lofty valuations. It would do so by raising the discount rate to be applied to company earnings.
All of this is not to question the justification of Trump’s going to war with Iran to prevent it from acquiring nuclear weapons. Rather, it is to argue that by exacerbating the inflation problem and by heightening the risk of an economic recession, Trump is jeopardizing his chances in the upcoming midterm election.
