proposal

The Trump Administration's Economic Policies and the U.S. Economy Risks Emerging in the U.S. Economy Amid Strong Equity Market and Economic Growth

At the outset of the second Trump administration, Treasury Secretary Scott Bessent and Commerce Secretary Howard Lutnick emphasized several economic and financial challenges. This paper reviews economic and financial developments to date. As only one year has passed since the administration's inauguration, any final assessment would be premature; the following should therefore be regarded as an interim evaluation. Despite the robust equity market and economic growth at present, this paper identifies three risk factors currently emerging in the U.S. economy.

1. What Happened to Inflation Concerns from Higher Import Tariffs?

At the beginning of 2025, several U.S. think tanks and economists widely warned that large increases in import tariffs—one of the Trump administration's flagship policies—would raise import prices, push up domestic inflation, and complicate macroeconomic policy management.

Based on the two tariff-hike scenarios discussed at the time, the author projected that headline CPI inflation would rise from the 2.0～2.9 percent range to between 4.1 and 4.5 percent year-on-year. Some institutions published even higher forecasts. In reality, however, inflation remained broadly in the 2.5～3.0 percent range, standing at 2.7 percent year-on-year in December 2025. Although it has been above the Federal Reserve's 2.0 percent target level, inflation did not exceed 3.0 percent. 1

Three factors can explain why inflation undershot the initial forecasts. First, the announced tariff hikes were partially scaled back during implementation (so-called "TACO": Trump Always Chickens Out). Second, foreign exporters reduced dollar-denominated export prices to limit sales losses. Third, U.S. importers and retailers absorbed part of the cost caused by the tariff hikes by lowering their margins, thereby limiting pass-through to consumers.

Regarding the first factor, it is necessary to examine changes in the effective U.S. import tariff rate. According to calculations by The Budget Lab at Yale University in "State of U.S. Tariffs: Jan. 17, 2026," the effective rate rose to roughly 28 percent in May 2025. Then it turned to decline, remaining at around 17 percent as of November 2025 (Figure1) 2

Figure 1

With respect to the second and third factors, estimates released by the Kiel Institute for the World Economy in Germany in January 2026 indicate that only 4.0 percent of the burden generated by higher U.S. import tariffs was absorbed through reductions in dollar-denominated prices by foreign exporters, while the remaining 96 percent was passed on to U.S. importers and consumers. 3

In addition, the National Bureau of Economic Research published a working paper analyzing tariff pass-through to retail prices (Cavallo, Llamas, and Vazquez, November 2025). It reports that prices began rising immediately after the Trump tariff measures of March 2025 and continued to increase gradually over subsequent months, with imported goods showing roughly twice the rate of increase observed for domestically produced goods. The estimated pass-through rate of tariffs to retail prices is 20 percent, and by September 2025 the cumulative contribution to the all-items consumer price index amounted to approximately 0.7 percent. 4

Applying this estimated cumulative contribution of +0.7 percent directly to the observed inflation rate of 2.7 percent year-on-year in December 2025 implies that, absent the tariff hikes, inflation rate would have been close to 2.0 percent.

It should be noted that perceptions of price increases differ somewhat between policymakers and economists on the one hand, and the general public on the other. Policymakers and economists tend to regard the problem as largely resolved once the year-on-year inflation rate declines to the 2 percent range after the surge of prices. By contrast, consumers often use past price levels as a reference point and remain dissatisfied for years with prices that stay elevated even after inflation rate subsides. This issue will be revisited later. (Figure2)

Figure 2

2. GDP Growth Boosted by the AI Investment Boom

Turning next to cyclical economic trends, real GDP growth contracted by an annualized quarter-on-quarter rate of 0.65 percent in the first quarter of 2025, but the growth averaged +2.5 percent through the third quarter, indicating solid overall performance.

However, it is important to note the rising contribution of the AI investment boom. From the first quarter of 2025 onward, the contribution of IT-related private fixed investment to real GDP growth increased sharply. If the investment in this sector had merely remained flat, the averaged growth across the three quarters of 2025 would have fallen to an average of +1.4 percent. (Figure3)

Figure 3

Labor market trends reveal that, rather than generating broad-based employment gains, the AI investment boom has—at least in the short to medium term—reduced employment primarily among college-educated white-collar workers, giving rise to what can be described as a "job-loss expansion." Meanwhile, manufacturing employment, which higher import tariffs were expected to support, has remained essentially flat after the post-pandemic rebound ran its course. (Figure 4)

Figure 4

Economic momentum has thus become increasingly dependent on AI investment. While equity indices remain firm, the performance is being driven disproportionately by a limited number of AI-related stocks. As a result, concerns about an "AI bubble" have begun to surface in the equity markets. Whether a collapse akin to the early-2000s IT bubble will occur is beyond the scope of this paper. Nevertheless, given the growing dependence of both the real economy and equity markets on AI investment, a future adjustment in the AI investment boom could generate a substantial negative shock. This constitutes the first risk identified in this paper.

3. Firm Equity Market and Declining Consumer Sentiment

Next, it is worth noting that consumer sentiment has been declining since 2025. Figure 5 shows the trends of the University of Michigan and Conference Board consumer sentiment indexes alongside the S&P 500 stock index. In the United States, consumer sentiment indexes and stock indexes have generally fluctuated with a positive correlation.

This is, of course, due to the positive correlation between economic activity and stock price fluctuations. However, this is not the only reason. In the United States, where indirect and direct stock holdings account for a high proportion of household financial assets, from the top to middle income brackets, rising stock prices increase the market value of stock holdings, making consumers more optimistic. This, in turn, confirms a positive wealth effect, which leads to increased consumption. Given these circumstances, it is easy to see the positive correlation between stock price indexes and consumer sentiment fluctuations.

In 2025, however, this relationship reversed: the equity prices remained firm while the consumer sentiment deteriorated. Several factors may explain this decline in sentiment. First, although inflation peaked at 9 percent year-on-year in 2022 and has since slowed, price levels remain elevated. Second, housing prices surged during the same period, with the S&P CoreLogic Case-Shiller U.S. National Home Price Index reaching a year-on-year increase of 20 percent at its peak. Third, as noted earlier, AI-driven job losses have been concentrated among college-educated white-collar workers.

Figure 5

Price increases must be assessed relative to wage growth. Median real weekly wages for full-time workers in the United States, adjusted for inflation, were 2 percent lower in the third quarter of 2025 than five years earlier. As a result, even as inflation moderates to the upper 2 percent range, widespread dissatisfaction persists among consumers because wage growth has failed to keep pace with rising living costs over recent years.

This decline in consumer sentiment, particularly among middle- and lower-income households, represents the second risk identified in this paper. Such dissatisfaction is reflected in falling approval ratings for President Trump, which have declined from 47 percent immediately after inauguration to 36 percent as of December 2025, according to Gallup. The concerns are also mounting within the Republican Party ahead of the November midterm elections.

4. Trends in the Trade Balance and External Imbalances

Next, let's look at trends in the U.S. trade deficit and external imbalances, which the Trump administration has placed great importance on. As Figure 6 shows, the trade deficit (negative values ​​are deficits) expanded sharply in the first quarter of 2025 due to last-minute imports increased sharply before the tariff hikes. Then, the deficit fell sharply in the second quarter as a reaction to this. The deficit continued to decline in the third quarter, but it will take some time to determine how much of this decline is a reaction to the first quarter and how much of this trend will become sustainable.

Looking at changes in the trade deficit by country (Figure 7), while the deficit with China has fallen sharply, it has widened with Taiwan, Vietnam, and Mexico. The widening deficit with Vietnam and Mexico in particular suggests that indirect exports (imports from the United States) are occurring from around the world.

If, as the administration hopes, exports from overseas companies to the United States shift to local production in the United States, then foreign direct investment in the United States should trend upward, but data up to the second quarter of 2025 shows no change in the growth rate of foreign direct investment in the United States. However, it is probably too early to assess this point at this point.

Figure 6

Figure 7

5. Fiscal Balance and Federal Debt

Monthly data since the inauguration of the Trump administration indicate an average federal deficit of USD 150–160 billion per month, broadly unchanged from the latter years of the Biden administration. According to the Congressional Budget Office's March 2025 projections, however, the federal deficit is expected to average 6.3 percent of GDP over the next 30 years, with federal debt rising from 107 percent of GDP in 2029 to 156 percent by 2055.5 These projections predate the enactment of the One Big Beautiful Bill (OBBB) and thus do not incorporate its effects.

While tariff revenue, which the Trump administration often boasts as an "achievement," is certainly increasing, the total amount for fiscal year 2025 (October 2024 to September 2025) will be $195 billion. This is only 3.7% of the total fiscal year revenue of $5.235 trillion.

Even if we assume that the tariff hikes lasted only six months in the last fiscal year and that they will double in the next fiscal year, given that the fiscal deficit already exceeds 6% of GDP, this will not be enough to cover additional tax cuts or the significant increase in defense spending from $900 billion to $1.5 trillion (fiscal year 2027) that President Trump announced in January 2026.

Let's take a look at the outline and expected impact of the OBBB (One Big Beautiful Bill), which was enacted in July 2025 at the initiative of the Trump administration. Based on a report by Daiwa Institute of Research (Fujiwara and Yahagi 2025)6, the following points can be summarized:

  1. (1) Impact on the fiscal balance: $3.4 trillion deficit increase on a basic fiscal balance basis over 10 years
  2. (2) Tax cuts: permanentization of Trump 1.0 tax cuts (for individuals and businesses), etc. ($4.5 trillion)
  3. Expenditure increases: Strengthened measures against illegal immigration ($0.3 trillion)
  4. Expenditure decreases: Medicaid cuts ($1.4 trillion)
  5. (3) Impact on the economy: The negative effects of tariff hikes and the positive effects of tax cuts will likely offset each other

6. The Expansion of the U.S. External Trade Imbalance

Finally, I would like to touch on the recent trend in the U.S. external trade imbalance. The Trump administration has expressed strong dissatisfaction with the long-standing U.S. trade deficit. It is a consensus of economists that President Trump's assertion that the U.S. trade deficit is a loss for the United States and a gain for the exporting country is complete nonsense from an economic view point.

However, as a result of the long-term trade and current account deficits, the US net external liabilities (the difference between external assets and liabilities) has been expanding as a percentage of GDP. Many economists have warned that this is "unsustainable in the long term." Nevertheless, it has continued over the long term. Moreover, in the field of international finance, this issue has been discussed in relation to the sustainability of the dollar's status as the world's key currency.

In this article, I would like to point out two changes that have occurred in recent years in the US external imbalance. First, let's look at the trend in the US current account balance (Figure 8). Within the trade balance, the services balance is in surplus, but the goods balance has been in deficit several times larger than that since the 1980s, and the current account deficit, which includes the income balance, has also been expanding, recording an annual deficit of over $1 trillion in recent years.

Figure 8

A constant current account surplus (flow), as in Japan's case, results in an increase in net external assets (stock), but a constant current account deficit results in an increase in net external liabilities. This is shown in Figure 9. Net external liabilities, which are the difference between external assets and liabilities, recently exceeded $25 trillion (approximately 90% of GDP).

Related to this the two changes are pointed out. First, the surplus in the balance of primary income (the balance between dividends & interests received from overseas and payments to overseas), which had been in surplus for a long time, has disappeared and has started to turn into a deficit since 2025 (Figure 10).

Figure 9

Even after the 1980s, when the United States became a net external liability position, the income balance remained in surplus. This was mainly the result of the higher income returns from foreign direct investments of the United Sates, while the cost of the foreign liabilities is lower than that. As a result there has been a positive return gap (1～2% per year) between the return of foreign income received and the cost of income payments to overseas.

Figure 10

Although this positive return gap remains, the expansion of net foreign liabilities, which now accounts for 90% of GDP, has made it impossible to maintain a surplus in the income balance, and it has turned into a deficit. The Trump administration is negotiating with major countries with a stance of "producing in the United States (foreign direct investment) rather than exporting to the United States," but it should be noted that this also has the effect of resulting in an increase in the deficit in the income balance.

The second change is that the U.S.'s external assets and liabilities have shifted from macro capital gains to capital losses. Let me explain this point. First, if there are no changes in the prices of external assets and liabilities calculated in dollar terms, the past cumulative current account balance will match the changes in net external liabilities (or net assets).

However, among the United States' external assets, assets denominated in foreign currencies (stocks, bonds, loans, real estate, etc.) fluctuate with changes in their foreign currency prices and the exchange rate of the dollar. Meanwhile, the majority of U.S. external liabilities are denominated in dollars, and naturally, their market value also fluctuates. If the overall valuation gains and losses arising from price fluctuations on these external assets and liabilities are positive for the United States, they become capital gains, and the increase in net external liabilities, assessed at market value, will be smaller than the cumulative current account deficit by just this macro capital gains.

Chart 11 shows these macro capital gains and losses. Capital gains occurred from the 2000s to the 2010s ("Change in net external liabilities - accumulated deficit of the current account balance" was negative), and their size peaked at $5 trillion. This means that net external liabilities were $5 trillion smaller than the accumulated current account balance at that time.

The main factors behind this are as follows: 1) The fall in the dollar exchange rate resulted in exchange rate valuation gains on foreign currency-denominated assets held by the United States, and 2) there was a significant asymmetry between assets and liabilities of the U.S., with a high proportion of stocks (securities investments and direct investments) in U.S. external assets, while the proportion of U.S. Treasury bonds held by overseas governments and private sectors was high on the liability side. Capital gains were generated from stocks, which accounted for a high proportion on the asset side, but not from bonds, which accounted for a high proportion on the liability side, assuming they were held to maturity.

However, since 2020, capital gains have turned into capital losses (negative values ​​on figure11), and the amount will exceed $10 trillion by the end of 2024. Why did this turn happen? It is because the above circumstances have been reversed.

Figure 11

In other words, (1) the dollar has shifted from a general downward trend to a stronger trend, causing the dollar-equivalent value of U.S. assets denominated in other countries' currencies to shrink. (2) Direct investment in the U.S. from overseas, including Japan, and equity holdings in securities investments from overseas have increased, and the U.S. stock market has had the highest return in stock prices in major countries over the past decade, so overseas investors' capital gains on U.S. stocks have increased (= capital losses on the U.S. side have increased).

These changes were predicted or pointed out by the author in an article in September 2024, and since then, changes in that direction appear to have accelerated somewhat. 7

As described above, the US's external imbalance problem has seen the disappearance of its two previous advantages - an income balance surplus and huge capital gains on its external position - and the resulting disadvantage of an income balance deficit and macro-level capital losses. While this problem will not immediately lead to a kind of crisis, it appears increasingly likely that in the medium to long term the US economy will enter a period of major adjustment, including a possible decline in the dollar. This is the third risk to the US economy that this paper points out.

(Masaharu Takenaka, Professor Emeritus, Ryukoku University)

proposal
current topics
letter