Last Wednesday, the Treasury Department announced a record monthly budget surplus for April of $308.2 billion. The report elicited no noticeable market reaction, as investors continued to fret about high inflation today and slowing growth in the months ahead. However, a Federal Reserve recognition of the economic implications of a fast-falling budget deficit could hold the key to a recovery in recently battered stock and bond markets. 

The April surplus suggests a huge decline in the budget deficit for the fiscal year as a whole. Moreover, with the current razor-thin Democratic majority in Congress likely to be followed by divided government after the mid-term elections, further fiscal stimulus looks unlikely, paving the way for further deficit reduction in fiscal 2023. This rapidly falling deficit should ease the worries of those who fear a near-term fiscal crisis. Fiscal drag also looks like a potent inflation antidote. However, it does increases the risk of a 2023 recession given the additional economic braking power from monetary tightening and a high dollar—the key question is whether the Federal Reserve will respond to much more fiscal tightening with some softening of its recently hawkish messages and actions.

The Numbers
To appreciate just quickly the deficit is falling, it is important to take a look at some recent budget numbers, bearing in mind that the federal fiscal year runs from October 1 of the prior calendar year to September 30 of the current calendar year.

The federal deficit rose from a trough of $587 billion, or 3.2% of GDP in 2016 to $984 billion, or 4.7% of GDP in 2019. Emergency pandemic assistance then boosted it to $3.1 trillion or 15% of GDP in fiscal 2020 followed by a small decline to $2.8 trillion or 12.4% of GDP in fiscal 2021. These annual deficits boosted the national debt from 77% of GDP in 2016 to 100% of GDP by the end of fiscal 2021.

For fiscal 2022, it has been particularly challenging to estimate the deficit until now due to the complicated impacts of the whipsaw pandemic recession and government programs. This uncertainty was always going to concentrated into April of the current year as the government paid out refunds and received annual payments on taxes for 2021. However, with April data in hand, it should be easier to project the rest of the year.

On May 25, the Congressional Budget Office will be releasing their fiscal projections for the next decade and should provide a pretty accurate forecast for this year and next. However, as a rough back-of-the-envelope calculation, we assume that both revenues and outlays over the next five months will be up 17.5% from 2019 levels (that is to say, roughly in line with the growth in nominal GDP over the same period), adjusting for the impact of some month-end days falling on weekends.

This calculation suggests a budget deficit of roughly $830 billion for fiscal 2022, or just 3.4% of GDP. Moreover, since the first quarter of fiscal 2022 was actually October through December of 2021, the fiscal 2022 deficit will still be impacted by some government pandemic programs. In the absence of these effects in fiscal 2023, the deficit could fall to roughly $780 billion or 3.0% of GDP. As a result, while government debt would still be rising, it would likely be rising more slowly than GDP, cutting the debt-to-GDP ratio to roughly 95% by September 30th of next year. 

Prospects For Fiscal Policy Change
These are, it should be re-emphasized, very rough estimates and they depend on two key assumptions, namely, that the economy slows to a soft landing rather than falling into recession and that we see no further policy changes in the next few years.

The first assumption is a close call depending, in part, on little bit of economic luck and, in part, on Federal Reserve restraint.

However, the second assumption appears to rest on more solid ground. The president’s Build Back Better agenda appears stalled, lacking the 50 Senate votes necessary to enact further fiscal stimulus. Between now and the mid-term elections, we will likely see some addition federal money spent on supporting Ukraine and, perhaps, paying for additional Covid testing, vaccines, treatment and research. However, there appears to be little appetite to enact further fiscal stimulus while the economy grapples with inflation caused by excess demand. In addition, in the absence of further government spending initiatives, it is unlikely that the Administration will push for significant tax changes.

Historically, the vast majority of mid-term elections have resulted in losses for the president’s party and given the Democrats’ narrow majorities in both the House and Senate, it is likely that Republicans will take over one or both houses of Congress in November.  If this transpires, we are also likely to see very little fiscal policy change over the following two years. This should result in roughly stable or slowly rising deficits though the end of 2024 with the debt-to-GDP ratio edging down further.

The Diminished Risk Of A Fiscal Crisis
One positive from a much smaller budget deficit is that it reduces the risk of a fiscal crisis.  Treasury markets have already demonstrated that investors are willing to fund the federal government even with the debt at 100% of GDP. If the debt to GDP ratio continues to fall slowly from here, it is unlikely that capital markets will suddenly become jittery about the ability of the Federal Government to meet its obligations.

The risk of another crisis concerning the federal debt ceiling also appears low as of today. In December of 2021, the president signed legislation increasing the federal debt limit by $2.5 trillion to approximately $31.4 trillion. While this was initially expected to forestall the need for any further increase in the debt limit until sometime in 2023, the failure of Congress to pass any further stimulus bills, along with much lower deficits, suggests no need to raise the debt ceiling again until 2024 or later. Notably, at the end of April, the federal debt subject to limit was roughly $1.05 trillion under the debt ceiling and the Treasury department had an additional $900+ billion on deposit with the Federal Reserve.

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