Nor does a government shutdown seem likely in the near term. The government is funded through September 30 and, provided the Administration can keep all Democratic senators on board, it should be able to send a reconciliation bill through this Congress to fund the budget for 2023. Thereafter, if Republicans take control of Congress, the risk of a shutdown increases. However, history suggests that the public blames Congress more than the Administration when government shutdowns occur, so even in a very partisan political atmosphere in 2023 and 2024, Republicans may focus on trying to achieve a political clean sweep in 2024 rather than getting into a shutdown dogfight with the current Administration.
Finally, some have worried that rising interest rates could precipitate a fiscal crisis. In this regard, it is worth noting that the federal government spent $352 billion in net interest costs in fiscal 2021 although this was offset by $82 billion in interest earnings by the Federal Reserve which they returned to Treasury, resulting in a true net interest cost of approximately $270 billion.
This number will rise due to higher interest rates, still rising federal debt and a reduction in the Federal Reserve’s Treasury holdings. However, on the first issue it is worth noting that the weighted average maturity of the federal debt rose to a record 72.6 months in the first quarter, with 48% of debt not maturing for at least three years. Since the government obviously only has to pay higher interest rates on the debt that it refinances, the impact of higher interest costs on debt service will take some years to ramp up. Similarly, the current $30 billion per month reduction in the Fed’s Treasury holdings, which is scheduled to climb to $60 billion per month starting in September, will only slowly add to the true net interest costs of servicing the national debt.
The bottom line is that there does not appear to be a short-term crisis brewing because of the size of the debt, political gamesmanship or rising interest rates. However, servicing the debt will become more onerous over time, limiting the ability of the government to increase spending or cut taxes.
The Economic Implications Of Fiscal Drag
While most financial media attention is focused on the Federal Reserve’s attempts to slow inflation by curtailing demand, the decline in the budget deficit is actually a much more potent force today. In particular, while a surge in wages and corporate profits has contributed to a decline in red ink, the deficit has mostly fallen due to a phasing out of business pandemic relief programs, an absence of further stimulus checks and the expiration of enhancements to unemployment benefits and the child tax credit.
The stimulus checks, enhanced unemployment benefits and enhancements to the child tax credit were all much more significant in relative terms for low and middle income households and contributed to surging spending on food and other basic goods during the pandemic. They also allowed many families to increase savings and pay down credit card debt. Total consumer credit actually fell by 0.3% in 2020 while the personal saving rate soared to 16.6% from 7.6% in 2019. That process has now gone into reverse with consumer credit rising by 9.7% annualized in the first quarter while the saving rate drifted down to 6.6%.
Changes in credit card borrowing and saving are temporarily muffling the impact of less fiscal stimulus. However, even with this, it is notable that real consumer spending on both food and clothing have now declined for three straight quarters following a surge in the second half of 2020 and the first half of 2021. Even with strong employment gains, this trend is likely to continue in the months ahead, squeezing the demand for goods and services while reducing some of the pressure on stretched supply chains.
Fiscal drag is, of course, only one of the factors currently slowing economic momentum. Domestic demand is also being hurt by a high dollar funneling money overseas to buy imports, higher gasoline prices, and higher interest rates curtailing housing demand. As of today, we still believe that there is sufficient pent-up demand for houses, vehicles, a wide swath of services and, of course, workers, to keep the economy on a growth path. However, the Federal Reserve will need to keep a very close eye on demand in the months ahead to make sure they are not adding too strong a dose of additional restraint on an economy already weathering the strongest fiscal drag since the end of World War II.
The Investment Implications Of A Falling Budget Deficit
It has been a miserable year so far for investors with heavy losses across both global equities and fixed income.
In this challenging environment, a fast-falling budget deficit could provide some relief by reducing the risk of either higher taxes or a fiscal crisis in the near future. However, it could be even more helpful if the Federal Reserve recognizes how much fiscal drag is reducing demand in the economy today and can contribute to lower inflation tomorrow. If the Fed does so and consequently slows its own aggressive moves to tighten policy, it will increase the likelihood of a soft landing for the economy and a rebound for financial markets in the rest of 2022 and beyond.
David Kelly is chief global strategist at JPMorgan Funds.