Post from First Trust Economics Blog

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist 

April 7th, 2025

The Federal Reserve started raising short-term interest rates

three years ago and the M2 measure of the money supply – what

Milton Friedman said to focus on – soon started declining, hitting

bottom in late 2023.

One of the great mysteries of the past two years is why,

given tighter money, economic growth didn’t slow down, much

less hit a recession. One reason was that the federal government

was engaging in the most reckless deficit spending in our

lifetimes. Don’t get us wrong, we don’t believe government

spending is good for the economy in the long-run. But, in the

short-run, it can make things feel better.

The federal deficit was north of 6.0% of GDP in both Fiscal

Year 2023 and 2024. To put that in perspective, during the

1980s, President Reagan was consistently criticized for running

overly large budget deficits. And yet the largest deficit of the

1980s was 5.9% of GDP in FY 1983, even as Reagan was fully

funding the Pentagon at the height of the Cold War and the

unemployment rate was 10%, meaning spending on

unemployment and welfare were elevated.

There were no similar excuses for the past two years, when

the jobless rate averaged less than 4% and we aren’t at war. We

think the enormity of these deficits, relative to economic

conditions, temporarily masked or hid some of the pain from the

tightening of monetary policy.

But now fiscal policy has gone in reverse, unmasking that

economic pain. The Trump Administration is cutting

government spending, via DOGE and otherwise, while

simultaneously raising taxes via higher tariffs. According to the

Tax Foundation, the Trump tariffs – those recently announced

plus those already implemented – would raise revenue by 0.85%

of GDP, making them the largest peacetime tax increase since

1982, even larger than the Bush tax hike of 1990, the Clinton tax

hike of 1993, or the tax increases enacted under Obama. Note

that the Tax Foundation’s score is static, in the sense that it

assumes no major shift in the location of production or buying

habits back to the US, so that 0.85% estimate could easily be too

high, but only time will tell.

Regardless, at least in the short term, these new tariff

increases could more than fully outweigh an extension of the

2017 Trump income tax cuts, because most of what gets enacted

later this year is likely to just be an extension of current policy.

In other words, unless the income tax law enacted later this year

includes a substantial deepening of the 2017 tax cuts, the total

burden of taxes will be higher in 2026 than in 2024.

Hopefully the new US tariffs are a prelude to lower trade

barriers against US products abroad, in which case our tariffs can

come down, as well. We are hopeful on that front. But the

formula used to calculate the new tariffs – based on our trade

deficit with each country rather than the level of their tariffs –

suggests that other countries simply reducing their tariffs might

not be enough for the Trump Administration to relent on higher

tariffs.

In the meantime, the economy has suddenly shifted from

being artificially held up by overly large budget deficits to being

exposed to temporary pain. Right now, it looks like US Real

GDP will be roughly flat to down in the first quarter (initial

release on April 30). And now consumers have to pay more for

foreign goods, at the same time that businesses that might think

of avoiding tariffs by putting or expanding operations in the US

have to worry about how long the new tariff policies will stay in

place. Why build a new plant here if the tariffs might be gone by

the time you finish? As a result, recession risk is rising and we

already thought a recession was overdue earlier this year.

Obviously, the tariffs have been the catalyst behind the

recent drop in stock prices. And stocks may go lower from here.

But stocks were overvalued even before the tariffs and if tariffs

weren’t the trigger for the drop in stocks, something else would

have been. That’s why we were willing to stick our necks out

late last year and forecast 5,200 on the S&P 500 for this year

while the rest of the industry was telling their clients stocks were

headed higher.

Depending on the outlook for earnings, the S&P 500 is now

basically at fair value, a major change from where it’s been for

the past few years.