How Political Gridlock in Washington Will Affect US Economy

Even though not all House and Senate seats have been called yet, the Republican lead in the lower chamber is indisputable, meaning further limits on Joe Biden's political initiatives.

The divided government with the GOP in control of at least one chamber of Congress and a Democratic White House may pose economic challenges over the next two years.

It is likely that the GOP-led House of the 118th Congress will further focus on inflation and the already unfolding technical recession in the US. Since autumn 2021, Republicans have been blaming the Biden administration's anti-fossil fuel "green" agenda and spending spree for the energy crunch and soaring prices. Therefore, one might expect that the House GOP will revise or altogether block Biden's spending and stimulus initiatives, which are considered to be "too generous."

Previously, Democratic lawmakers signaled that they intend to proceed with Biden's broad fiscal agenda proposed in 2021 that has not yet become law. Over the past few years, the Biden administration has managed to pass only a fraction of its multi-trillion Build Back Better initiative, being opposed not only by Republicans, but also moderate Democrats in the US Senate.

It is likely that the Dems will have to shelve their bold spending plans, thus potentially shielding the US economy from a greater spike in inflation. Likewise, US multi-billion aid packages, including for Ukraine, may be subjected to revision and reduction by House Republicans. At the same time, domestic federal programs, such as Social Security and Medicare, could also be subjected to cuts. Still, observers expect that the overall US defense spending will not be impacted.

The debt ceiling issue is likely to trigger a heated debate, with the GOP obtaining leverage in dealings with the Biden administration. The federal debt ceiling was last raised in December 2021, with the US Treasury expected to reach its mandated $31.4 trillion borrowing limit in 2023. That means this limit will need to be raised again in order to ensure that the US can borrow the money it needs to finance the government and proceed with federal spending. However, Republicans earlier signaled that if they win the lower chamber, they would use this opportunity to draw the nation's attention to the country's rapidly growing debt and demand federal cuts in exchange for boosting the ceiling.

If the government ends up in a stalemate, the markets will go down. The last time this crisis took place was in 2011, under the Obama administration, when stocks dropped more than 5% and the US lost its excellent AAA credit rating from Standard & Poor.

As the US recession may translate from a "technical" to a real one in 2023, relief programs will likely be on the table of the Biden administration. The GOP, for its part, is expected to put the brakes on the president's stimulus measures, due to at least a couple of reasons. First, they have long been against the federal government handing out big sums of money, which, according to the Republicans, is only fuelling already high inflation. Second, the GOP is by no means interested in helping the Biden administration look "favorable" in the eyes of American voters, given the Republicans' 2024 ambitions. However, this potential approach could be double-edged, since the Democrats may use the situation to shift the blame onto the GOP for the plummeting living standards in the US. Under these circumstances, the two major parties will have to negotiate hard to reach a compromise.

Biden is considering a windfall tax on Big Oil companies after the latter made record profits on high gas prices. According to American observers, Republicans are traditionally not in favor of slapping additional taxes on the energy sector or other industry giants; therefore, they would be less likely to approve a windfall tax on oil company profits.

Vice versa, the Republicans will face certain difficulties in pushing any major tax reductions, given the Dems and the incumbent president's opposition. This potential stalemate won't benefit the US economy. Earlier this year, Biden signed the Inflation Reduction Act into law, passed by the Democratic majority in the US Congress, which imposed a 15% corporate minimum tax aimed at companies that earn more than $1 billion a year. Republican lawmakers argued that the measure could be harmful for American businesses. In particular, Sen. Mike Crapo, the top Republican on the Senate Finance Committee, released an analysis in August 2022 indicating that the corporate minimum tax would raise taxes on low- and middle-income people.

The future divided government is also likely to influence markets, as a Republican win in one or both chambers is likely to lead to policy gridlock. According to US financial analysts, the US stock market tends to drop before the midterms and rally after them, regardless of the party in power. Furthermore, they noted that since 1950, the S&P 500 has outperformed whenever the midterms ended in a Republican-controlled Congress and a Democratic president.

However, this time, Wall Street ended sharply lower than expected on November 9. The Dow Jones Industrial Average DJIA fell 647 points (-1.95%), the S&P 500 SPX declined 80 points (-2.08%), and the Nasdaq Composite COMP dropped 263 points (-2.48%). The slump is explained by failed market expectations of a "red wave," as well as the fact that the outcome of the election is still unclear.

Other market watchers suggest that looming inflation data that may pave the way for new Federal Reserve interest rate hikes is also at play. Impending drama over the 2023 debt ceiling hike could backfire negatively on markets as well. And the prospects of recession do not make the overall picture any brighter. However, there is a silver lining for investors: the Republican House is unlikely to allow Biden to introduce any tax hikes for US businesses. Time will tell how the political gridlock in Washington will pan out for the US market this time.