(Bloomberg) – The government spending cap in Washington's agreement to raise the federal debt ceiling is creating new headwinds in a US economy already weighed down by the highest interest rates in decades and limited access to credit.
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The tentative deal that President Joe Biden and House Speaker Kevin McCarthy hammered out over the weekend — assuming it passes Congress in the coming days — averts the worst-case scenario of a default triggering a financial meltdown. But it could also, albeit slightly, increase the risk of a downturn in the world's largest economy.
Federal spending over the past few quarters has helped support US growth amid headwinds, including a slump in home construction, and the debt ceiling agreement should at least dampen that momentum. Two weeks before the debt-limit agreement, economists had put the likelihood of a recession next year at 65%, a Bloomberg poll showed.
For Federal Reserve policymakers, the spending ceiling is a new consideration to take into account as they update their own growth and interest rate forecasts, which are due to be released on June 14th. At the end of last week, futures traders were pricing in no change. Rates were cut for the mid-June monetary policy meeting, with a final hike of 25 basis points in July.
“This will make fiscal policy a bit tighter, while at the same time monetary policy is and is likely to become tighter,” said Diane Swonk, chief economist at KPMG LLP. “For us, both policies run in opposite directions and reinforce each other.”
The spending caps are expected to take effect from fiscal year commencing October 1, but it's possible that small impacts will materialize before then – such as Covid aid clawbacks or the impact of the phasing out of student debt forbearance. However, these are unlikely to show up in the BIP accounts.
Tobin Marcus, senior US policy and policy strategist at Evercore ISI, also noted that assessing the extent to which spending limits are “mere gimmicks” will be important as negotiators seek to bridge differences through accounting maneuvers.
With spending for the coming fiscal year expected to remain around 2023 levels, the actual restrictions imposed by the deal would come into play at a time when the economy might be shrinking. Economists surveyed by Bloomberg were already assuming an annual decline in gross domestic product of 0.5% for the third and fourth quarters.
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“In a recession, fiscal multipliers tend to be higher. So if we do enter a downturn, reduced government spending could have a larger impact on GDP and employment,” said Michael Feroli, chief US economist at JPMorgan Chase & Co. in an email response to questions.
Still, Feroli's latest thought remains with JPMorgan's base case that the US could avoid a recession.
Despite the Fed raising interest rates by about five percentage points since March last year – the centerpiece of the most aggressive monetary tightening campaign since the early 1980s – the US economy has so far proved resilient.
Thanks to historically high labor demand, unemployment is 3.4%, its lowest level in more than half a century. A recent San Francisco Fed study showed that consumers still have excess savings to use due to the pandemic.
Fed officials will have a number of considerations because apart from the deal's impact on the economic outlook, there will also be some implications for money markets and liquidity.
The Treasury has reduced its cash balance to continue making payments since hitting its $31.4 trillion debt ceiling in January. Once the cap is lifted by upcoming legislation, it will ramp up sales of Treasury bills to replenish that stock back to more normal values.
This wave of new government bond issuance will effectively drain liquidity from the financial system, although its exact impact may be difficult to gauge. Treasury officials can also prompt the issuance in a way that minimizes disruption.
The fact that the Fed is draining liquidity on its own, unwinding its bond portfolio at a rate of up to $95 billion per month is a dynamic that economists will be watching closely in the coming weeks and months.
Read more: Debt relief may be brief as focus turns to flood of Treasury bills
In the longer term, the size of the fiscal restrictions being worked out by the negotiators will almost certainly do little to contribute to federal debt developments.
The International Monetary Fund said last week that the US would have to cut its primary budget — that is, excluding debt interest payments — by about five percentage points of GDP “to significantly reduce public debt by the end of this decade.”
Keeping spending at 2023 levels would fall short of such great restraint.
“The two-year spend caps that are 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 stable, which will represent minimal fiscal headwinds for the economy while only marginally reducing deficits.”
– With support from Josh Wingrove, Jennifer Jacobs and Erik Wasson.
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