Debt deal puts brakes on US economy already at risk of recession

(Bloomberg) – The government spending cap in Washington’s deal to raise the federal debt ceiling adds fresh headwinds to a U.S. economy already burdened by the highest interest rates in decades and access reduced to credit.

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The tentative deal hammered out by President Joe Biden and House Speaker Kevin McCarthy over the weekend — assuming it passes Congress in the coming days — avoids the worst-case scenario of a default. triggering a financial collapse. But it could also, albeit at the margin, add to the risks of a slowdown in the world’s largest economy.

Federal spending in recent quarters has helped support US growth in the face of headwinds, including a slump in residential construction, and the debt-limiting agreement should at least dampen that momentum. Two weeks before the debt limit agreement, economists had calculated a 65% risk of a recession in the coming year, according to a Bloomberg survey.

For Federal Reserve policymakers, the spending cap is a new consideration to take into account as they update their own growth projections and benchmark interest rate, due out June 14. rates for the mid-June monetary policy meeting, with a final hike of 25 basis points in July.

“This will make fiscal policy slightly tighter at the same time that monetary policy is tight and likely to get tighter,” said Diane Swonk, chief economist at KPMG LLP. “We have the two policies that are moving in opposite directions and amplifying each other.”

Spending limits are expected to be enforced from the fiscal year beginning October 1, although it is possible that small effects will show up before then – such as through the recovery of Covid aid or the impact of phasing out student debt forbearance. However, these are unlikely to show up in the GDP accounts.

Tobin Marcus, Evercore ISI’s senior U.S. political and policy strategist, also said it would be important to assess the extent to which spending limits are “pure gimmicks” as negotiators seek to bridge differences through maneuvers. accountants.

Even so, with spending for the coming financial year expected to be kept around 2023 levels, the restrictions imposed by the deal would come into effect at a time when the economy could be in contraction. Economists polled by Bloomberg had previously forecast a 0.5% annualized decline in gross domestic product for the third and fourth quarters.

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“Fiscal multipliers tend to be higher in recessions, so if we were to enter a recession, cutting fiscal spending could have a bigger impact on GDP and jobs,” said economist Michael Feroli. Chief American at JPMorgan Chase & Co. in an email response to questions.

Still, Feroli’s latest thinking stays true to JPMorgan’s baseline scenario that the US avoids a recession.

Despite about 5 percentage points in Fed rate hikes since March of last year – the centerpiece of the most aggressive monetary tightening campaign since the early 1980s – the US economy has so far done proof of resilience.

Unemployment is at its lowest in more than half a century, at 3.4%, thanks to historically high demand for labour. Consumers still have excess savings to use due to the pandemic, a study by the San Francisco Fed recently showed.

Fed officials will have a range of considerations, as in addition to the deal’s impact on the economic outlook, it will have implications for money markets and liquidity.

The Treasury has cut its cash balance to keep making payments since hitting the $31.4 trillion debt cap in January, and once the cap is suspended by upcoming legislation, it will increase debt. sales of treasury bills in order to rebuild this stock to more normal levels.

This wave of newly issued Treasuries will effectively drain liquidity from the financial system, although its exact impact may be difficult to assess. Treasury officials can also arrange their issuance to minimize disruption.

With the Fed removing liquidity alone, depleting its bond portfolio at a rate of up to $95 billion a month, it’s a dynamic economists will be watching closely in the weeks and months ahead.

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In the longer term, the scope of fiscal restraint crafted by negotiators will almost certainly do nothing for the trajectory of the federal debt.

The International Monetary Fund said last week that the United States would have to tighten its primary budget — that is, excluding debt interest payments — by about 5 percentage points of GDP “to put the debt down. on a decidedly downward trajectory by the end of this decade”. .”

Maintaining spending at 2023 levels would be well within such a major restriction.

“The two-year spending caps at the heart of the deal are somewhat in the eye of the beholder,” Evercore ISI’s Marcus wrote in a note to clients on Sunday. His assessment: “Spending levels should remain roughly flat, posing minimal fiscal headwinds to the economy while only marginally reducing deficits.”

–With help from Josh Wingrove, Jennifer Jacobs and Erik Wasson.

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