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 30^th 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.

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.