The unexpected Election Day outcome changed the outlook for the U.S. economy. The day before the election, the outlook was for more of the same: real GDP growth near 2%, inflation less than 2%, an unemployment rate falling a bit below 5%, and very gradual increases in interest rates. That meant not much was going to change from 2014, 2015 or 2016. 

Once the realization that it would be a Trump administration set in, the outlook changed. The stock market has set new record highs, Treasury bond interest rates have increased, inflationary expectations have increased, and the value of the dollar has risen to 13-year highs. 

The economy is near capacity, with the unemployment rate at 4.6% in November. It will be harder for businesses to find new employees if they want to expand. That means that output growth is limited by the growth in the labor force. The labor force is growing slowly, only 0.9% over the past year, because baby boomers are retiring in large numbers. Output also depends on productivity, which is output per employee. That is influenced by the quantity of machinery and quality of technology that workers use. Productivity has actually been falling over the past year, down 0.3%. That’s unlikely to continue, but modest labor force growth plus modest productivity growth means that the economy’s capacity to increase production of goods and services is limited too. 

With the election, Federal fiscal policy could be unbound after six years of stalemate between the White House and Congress. Federal fiscal policy will likely become more stimulative to a higher rate of economic growth. There will likely be an income tax cut that will add to consumer and business spending, and perhaps increases in defense and infrastructure spending creating more jobs. Pressure from baby boom retirements and health care costs will keep entitlement costs rising. Substantial changes in Obamacare and Medicare may be a few years off but are now anticipated. All this means increased federal budget deficits. Federal borrowing will increase and push up interest rates. 

Consumer spending increased by 2.7% above inflation over the past year. There are many reasons to think that consumers will keep spending. Falling unemployment means job prospects keep improving. Wages have begun to rise. Home values and stock prices are up. Add a tax cut, and we can expect consumer spending to rise 3.3% next year. 

Investment in housing construction grew 1.5% above inflation over the past year, a slower pace than over the past few years. However, housing is still in short supply. Rising housing prices will encourage construction, and still-low mortgage rates should support demand. I am looking for a 5% increase next year. 

Other components of spending will show less growth. Investment in business buildings and equipment is falling, by 1.4% over the past year. Since business interest rates are very low, this decline must mean that businesses have low expectations for returns to expansion. Policy uncertainty over the next year might inhibit investment too. Trade growth has stagnated, falling as a share of total output, though exports grew 2% while imports grew 0.6% this past year, so trade was a small net addition to spending. A rising value of the dollar and slow growth abroad probably will hold down export growth. Trade restrictions could inhibit imports. 

Add it up, and spending is likely to rise by 2.3% over the next year. Can an economy at capacity, with a slowly growing labor force and slowly growing productivity, raise production to meet that new demand? 

In the short run the answer is probably yes. Real GDP is likely to increase by about 2.3%. The short supply of labor will raise wages, and some labor market indicators show several million people who could join the labor force with such encouragement. Faster labor force growth means that unemployment may not change very much in 2017. It should remain around 4.5% by next December. 

What about inflation? Added spending beyond capacity would encourage businesses to raise prices. Higher costs would do the same. OPEC oil producers intend to restrict supply, which should increase gasoline prices. The headline inflation rate has been 1.6% over the past year. With added demand, limited supply and higher gasoline prices inflation should run near 2.3% over the next year. 

Falling unemployment and higher inflation should embolden the Federal Reserve to raise their policy interest rate more frequently. We may see a quarter-point increase every three months, which would mean a one-point hike over the next year. The 3-month Treasury interest rate could rise from 0.5% now to 1.4% by next December and the ten-year Treasury rate may rise from 2.4% to 2.7%. 

Will the Trump administration really increase tariffs? Congress may resist. But markets have already anticipated lower demand for the Mexican peso. Its value has fallen and the dollar’s value has risen by about 10% since the election, which makes U.S. exports to Mexico more expensive. That may cost U.S. jobs in exporting industries like agriculture. If tariffs are imposed, some manufacturing activity may shift back to the U.S., though ever-increasing automation may limit the number of added jobs. Tariffs also would increase the prices that consumers pay, adding to inflation. 

Our 2017 story is one of tax cuts and rising government spending in an economy near capacity. Output and inflation will rise, countered by higher interest rates and a higher exchange value of the dollar. Unless, of course, policy doesn’t change. Then we’ll see slower growth, lower inflation, fewer interest rate hikes and slower increases in the dollar than in this forecast. 

What President Trump does will be important, but remember there is still a lot of uncertainty about what the new administration will actually do.