Goldman Sachs sees Trump leading to more aggressive Fed, 'ambiguous' growth outlook

Goldman Sachs economists expect Donald Trump's economic agenda to lift inflation and interest rates.

They expect to see a more aggressive Fed. They also initially expect higher growth thanks to a Trump plan to spend on infrastructure — bumping their forecast for U.S. GDP growth in the second half of 2017 by a quarter point.

But they also described the effect of Trump's economic plans as "ambiguous." While they see a bump in 2017's growth rate, they see the longer-term impact of higher tariffs, reduced immigration and tighter Fed policy weighing on growth as a stimulus boost fades.

"Markets have traded the Trump victory primarily as a sizable positive growth shock, a small higher inflation shock and a small adverse policy shock (which probably mainly reflects concerns about protectionism)," the economists said in a report. They see a steady rise in inflation to 2.2 percent, as measured by core PCE (personal consumption expenditure), by 2019. It currently stands at about 1.7 percent.

The economists also raised the odds of a December rate hike to 85 percent from 60 percent and said the election of Trump reinforces their view that the Fed will raise rates three times next year.

The Fed has forecast two rate hikes for next year, but the Goldman economists said Trump's proposals should "reinforce the move in inflation that is already underway." That and the fact that the current thinking on the equilibrium rate is too low, meaning the Fed could raise the funds rate "substantially" more than implied by the markets.

They noted that "aggressive implementation of Trump's trade and immigration policies would likely weigh on growth."

They trimmed 2019 and 2020 growth by a quarter point. Their current growth forecast is for annualized average U.S. GDP growth of 2.4 percent next year.

The economists also said global growth is now accelerating to the top of a 3 to 3.5 percent range it's been in due to improved financial conditions in the U.S. and the emerging world.

"The FCI-driven (financial conditions) acceleration in U.S. growth and the Trump-driven change in the growth and inflation outlook reinforce our forecast of tighter Fed policy. We have raised our subjective probability of a hike at the December FOMC meeting from 60 percent to 85 percent, and expect an additional 75 (basis points) of rate increases in 2017. This is above the FOMC's own 50 (basis point) projection because we have a higher core inflation forecast than the median FOMC participant, and also a slightly higher growth forecast," they wrote.

The tighter Fed policy would pressure global long-term interest rates, they note. That would likely lead the European Central Bank to extend its asset buying program, and the Bank of Japan would likely focus on its own plan to control yield.

These diverging policy efforts should put upward pressure on the U.S. dollar, the economists noted. The dollar index has been rising, and it hit a near 14-year high against a basket of currencies Wednesday.

Goldman economists say the risks around their baseline projections are "substantial and skewed to the downside."

"First, the Trump agenda and its effects on the economy are still very difficult to predict with confidence. In particular, greater emphasis on the trade or immigration aspects of the agenda would likely lead to more adverse outcomes even in the shorter term, and the harder-to-quantify effects on policy uncertainty is substantial," they wrote.

They also noted that the U.S. is not the only country with political risk. They pointed to an uncertain outlook around Brexit negotiations between the U.K. and European Union, as well as the upcoming Italian constitutional referendum. They said more important are concerns that Marine Le Pen could win the presidency of France in the spring. She has toned down her rhetoric but has previously promoted the idea that France should leave the euro.

They also added that the stronger dollar could be a risk to emerging economies, particularly China.