How could the US midterm election results impact the economy?

As American voters went to the ballot box for the midterm elections, many analysts believed a ‘red wave’ of Republican votes would threaten Democratic control over both the Senate and the House of Representatives.

However, the red wave failed to materialise and the results remain neck-and-neck. The Republicans look like they may eke out a victory in the House, but the Senate remains too close to call. A majority in the upper chamber of Congress will likely be decided by a run-off election on 6 December.

The impact on markets

The uncertainty is causing jitters among investors, as control over Congress could have huge implications for US monetary and fiscal policy, as well as for the world economy.

Inflation

For instance, Republican control of the Senate or the House would make it much harder to Biden to pass spending legislation.

Overall, Republican voters are more concerned about inflation than Democratic voters, and a key Republican line of attack has been to blame the Biden administration spending for surging inflation.

Therefore, the Republican Party will likely seek to block, water down or delay any spending plans. If they control Congress, we could see inflation ease in the US, which in turn may mean a slower pace of Federal Reserve interest rate rises and a weaker US dollar. However, scaled-back spending plans could mean slower US economic growth in 2023.

Gridlocked government

Generally speaking, markets react favourably to a divided Congress as it leads to a more centrist government. In other words, each party reins in the other, avoiding extreme policies and market volatility.

However, with the potential of an impending US recession, a deadlocked government could make things worse. In a note to clients, Morgan Stanley analysts wrote ‘In the event of recession, divided governments generally deliver only limited and late fiscal support’.

If America slips into recession and the US government lacks the agility to act, it could end up deepening and lengthening the downturn. Politically, this would play in the Republicans’ hands ahead of the 2024 elections.

US debt ceiling

One worrying potential outcome of the election pertains to the nation’s debt limit.

Under current law, the US Treasury is limited by a debt ceiling. If it needs to borrow money beyond this constraint – which will almost certainly happen next year – Congress must pass legislation to lift or suspend the limit.

If it doesn’t, the US would default on its debt. Federally funded programmes – defence spending, federal law enforcement, Social Security etc. – would run out of money. The impact would ripple out through the US economy and into global financial markets.

Some Republican politicians have signalled that they will use the threat of a default as leverage against the Biden administration to demand cuts to Social Security and Medicare. If this happens, the anxiety caused – even if a default is averted – could hurt the US economy and strain its financial system.