Gridlock in Washington
The mid-term elections have clearly been won by the Democrats, but we would prefer to describe this as a defeat for Trump. This is an important distinction, as the Democrats are a deeply divided party. We cannot expect them to adopt a unified policy.
Moreover, even if this were the case, they would still have too few seats to 'overrule' a veto by Trump. The end result is therefore likely to be that neither Trump and the Republicans nor the Democrats will achieve much in the near future. There are likely to be fierce battles between the two camps, without a clear winner emerging from the fray. This strongly suggests that, for the time being, little will be done about the far too large government deficit.
If we look at the results from a shorter-term perspective, two developments are of particular importance. Firstly, until recently, Trump consistently stated that the US would attack Iran again as soon as the mid-term elections were over, presumably in conjunction with Israel. To that extent, this makes sense, given that the new Congress does not take office until January and he will therefore have to deal with the old Congress until then.
This is significant because the new Congress is likely to cut off Trump's funding to expand the war. Trump can decide on his own to attack Iran again, but Congress controls the funding for such an action. If the president wishes to take further action against Iran, it therefore makes sense to do so quickly now.
Just before the elections, however, Trump said he did not wish to do this. Tehran may have made a gesture to seek a diplomatic solution. The question, however, is how seriously this should be taken. Iran may simply be seeking to ensure that new air strikes are postponed until mid-January, as the new Congress will likely try to prevent an escalation of the war after that time.
All of this is of great importance for the future trend in oil prices. New air strikes would mean a much higher oil price, whilst a diplomatic solution would result in significantly lower oil prices. In the first scenario, inflation would rise to such an extent that the Fed and the ECB will have to raise interest rates further. In the second scenario, however, they could keep interest rates steady, if not lower them.
We assume, incidentally, that not much will change for the time being, so we expect oil prices to move sideways or upwards rather than fall sharply.
Secondly, Western economies, and particularly that of the US, are currently being strongly boosted by massive investment in all things AI. The Democrats, however, want more regulation in this area, which could lead to significant delays. The question is whether the Democrats, who are also divided on this issue, will be able to get this sorted out quickly. We therefore suspect that there will be some delay, but not a great deal.
Monetary policy
For the financial markets, it is of great importance what all this means for the monetary policy of the Fed and the ECB. In fact, we do not think much will change. By this we mean the following.
Trump has acknowledged the Democrats' victory and is therefore unlikely to contest it. Had he done so, it would have created considerable uncertainty, resulting in slower economic growth and, consequently, no further interest rate rises for the time being. Nor does the result appear likely to have major implications for fiscal policy in the near future.
We therefore expect central banks to remain focused on curbing inflation.
In this regard, the Fed cannot be complacent about the current situation. According to the latest figures, the US economy continues to grow at around 3.5 per cent, well above its potential growth rate of around 2.5 per cent, and the labour market appears to be tightening. This argues in favour of a further interest rate rise. However, the central bank must also take a number of other factors into account:
- The price of oil has fallen sharply in recent days. If this trend continues, inflation will also fall.
- Even if investment in AI begins to decline, it will remain substantial enough to continue to provide a significant boost to the economy in the coming quarters. From the middle of next year, however, it will also lead to much wider use of AI. This may then result in a much stronger increase in productivity, which would reduce the risk of inflation.
- Minister Bessent wants the government to borrow more in the short term and less in the long term.
- Now that the results of the mid-term elections are known, more foreign capital may once again flow into the US. This could potentially provide the Fed with an additional reason to raise interest rates. However, this argument is often turned on its head. If the Democrats were to slow down the development of AI, this would mean less economic growth and, consequently, lower interest rates and a weaker dollar (we believe this is an overreaction).
Undoubtedly, there are other factors the Fed must take into account, but they are all too uncertain to base monetary policy on at this stage. We therefore believe that, given the high level of economic growth, the US central bank will continue to raise interest rates for the time being, but will do so very gradually. The challenge remains to find an interest rate level at which growth is held back to below its potential. In other words: raising interest rates by a further 0.25 percentage points each quarter, whilst monitoring how all factors develop in the months that follow. It is clear that inflation must be brought down, but care must be taken to avoid 'overkill'.
In principle, the same applies to the ECB, although the key difference is that there is no investment boom in AI in Europe. As a result, the European economy is growing at a significantly slower rate than that of the US. This means that the ECB will need to raise interest rates less than the Fed.
