The Monetary Implications of Fiscal Drag

Subscribe to the Notes on the Week Ahead newsletter to receive it directly in your inbox.

On many occasions in my adult life, I have made New Year’s resolutions to become fitter. As the days of the old year gradually dwindled and my girth gradually expanded, I would commit myself to exercise more and eat less. However, experience has taught me that both of these noble aspirations must be approached with moderation. Any attempt to starve myself while running more miles leads inevitably to physical slowdown or breakdown. Moreover, if I simply refuse to eat more, the exercise comes to a screeching halt. 

The Federal Reserve may be about to learn the same lesson with regard to current dramatic fiscal and monetary tightening. This combination seems set to trigger, at best, much slower economic growth and, at worst, outright recession. Moreover, for political reasons, it is unlikely that fiscal tightening will end any time soon. If this is the case, then despite their current resolve, the Fed may well have to turn from tightening to easing before the end of 2023.

The Deficit by the Numbers

Within the next few days the Treasury Department should announce a federal budget deficit for fiscal 2022 of roughly $1.4 trillion, down 50% from the year before. While this sounds like a very sharp decline, the true impact of deficit reduction, both from the perspective of the borrowing needs of the government and stimulus or drag imparted to the economy is even more dramatic. Moreover, deficits look likely to fall as a share of GDP over both the next two years. While this should allay fears that ballooning government debt could trigger a financial crisis, it increases the likelihood that the economy is in for a period of very slow growth or recession.

Our latest read on the federal budget comes from the Congressional Budget Office’s Monthly Budget review for September[1], the last month of fiscal 2022. One important aspect of the deficit numbers for 2022 is that they will include the entire present value cost of student loan forgiveness announced by the President in August which the Administration estimates at $426 billion. While this accounting conforms with the requirements of the Federal Credit Reform Act, it should be recognized that, as a practical matter, this money neither adds to the cash outlays of the federal government nor to its gross debt. In addition, the President’s plan is being challenged in court and may yet be overturned. Nevertheless, this does add substantially to the official deficit If this cost is included, we estimate that the deficit fell from 12.4% of GDP in fiscal 2021 to 5.6% in fiscal 2022. If the cost is excluded, the deficit fell to just 3.9% of GDP. 

In the absence of further legislation, the deficit could fall further to roughly $800 billion in fiscal 2023 or roughly 3.1% of GDP and something similar in 2024. From a political perspective, this outcome seems fairly likely. The latest polling suggests that there is a very good chance that Republicans will, at a minimum, take control of the House of Representatives in next month’s mid-term elections and, if they do so, they are unlikely to agree with the Administration on any further fiscal stimulus ahead of the 2024 presidential election.

The Reduced Risk of a Fiscal Crisis

One important aspect of recently falling deficits is that they reduce the risk of a fiscal crisis. The federal debt in the hands of the public peaked at 104.5% of GDP in the first quarter of 2021. By the end of the third quarter of 2022, we estimate that this ratio had fallen to 98.6% of GDP and it could fall to about 96.5% of GDP by the end of fiscal 2024, if the economy avoids outright recession. Since global financial markets appear willing to bankroll a federal debt of 104.5% of GDP without major disruption, financing a debt ratio which is somewhat lower should not lead to a market meltdown.

Nor is there a huge risk of a politically-manufactured fiscal crisis. Despite sharp partisan divisions, Congress recently passed a continuing resolution extending current funding for the budget through December 16th, suggesting that neither side has any appetite for a government shutdown. A second perennial source of Washington turmoil on the budget, the federal debt ceiling, also appears defanged for now. At the end of September, the federal debt was $512 billion below the debt ceiling while the Treasury Department had $662 billion in its checking account at the Federal Reserve. Combined, this amounts to $1.174 trillion of breathing room which should cover the deficit for the year ahead and could postpone the next debt ceiling fight until late 2023 or even early 2024.

The Impact of Fiscal Drag

Another very important aspect of the budget is how it impacts household income. The pandemic relief acts were enormous in economic terms and particularly directed money towards lower and middle income households through the enhanced child tax credit, enhanced unemployment benefits and means-tested stimulus checks. All of this essentially ended at the start of the year and the net effect has been to take a chunk out of consumer income.

In response, consumers have cut their savings and started to rack up credit card debt. The personal savings rate has averaged 3.5% over the past six months, far below the artificially high levels during the pandemic but also well below the 7.6% rate averaged over the five years prior to the pandemic. Credit card debt in August amounted to $1.154 trillion, up 15.3% year-over-year. 

Even with lower saving and increased borrowing, however, consumers are being forced to pull back. Last week’s retail sales report for September suggests that real consumer spending has been rising at a less than 1% annual rate over the last six months with real spending on food for home consumption falling at a 4% annual rate.

As some consumers exhaust savings or bump up against credit limits in the months ahead, we expect real consumer spending to remain very soft, even with continued job gains and wage increases. 

Of course, this slowdown in consumption won’t be the only drag on demand. According to Freddie Mac, the 30-year fixed rate mortgage rate hit 6.92% last week, up from 3.11% at the start of the year and at its highest level in over 20 years. This week’s readings on home-builder confidence on Tuesday and Housing Starts on Wednesday should underscore the depth of the sudden housing downturn. 

In addition, the dollar remains at extremely high levels with the trade-weighted exchange rate up roughly 20% year-over-year. While this has apparently not hurt trade data for the third quarter, this high exchange rate, combined with overseas economic weakness should lead to a trade drag on economic growth in the year ahead.

Fiscal drag is therefore be operating on an economy already encountering stiff headwinds. While unprecedented pent-up demand for labor and recent inventory shortages of autos and other consumer goods mean that recession is not inevitable, a long period of slow economic growth seems very likely.

Fiscal Policy and the Federal Reserve 

In the short run, the Federal Reserve appears to be entirely focused on high inflation and Fed officials have tended to downplay the deflationary effects of the fiscal, housing and exchange rate drags on the U.S. economy.

However, this is likely to change in the months ahead. Despite continued sharp increases in owners’ equivalent rent and stickiness in other aspects of services inflation, weaker prices elsewhere should allow inflation pressures to ease. Indeed, if CPI rises by an average of 0.3% per month over the next six months then year over year headline CPI inflation, which peaked at 9.0% in June and eased down to 8.2% in September could fall to 7.0% by December and 5.0% by March.

This, along with more obvious signs of economic weakness should allow the Fed to suspend further rate hikes early next year. One possible scenario is rate hikes of 0.75% on November 2nd, 0.50% on December 14th and a final 0.25% hike on February 1st, 2023, taking the federal funds rate up to a range of 4.25%-4.50%.

Thereafter, the Federal Reserve would probably like to hold interest rates steady and continue its program of quantitative tightening. However, by early next year, the economy will likely be on the edge of recession with inflation falling rapidly. If this transpires, and no further fiscal stimulus is in sight, then the Fed may well have to capitulate, suspending quantitative tightening and cutting interest rates both in late 2023 and in 2024. This could also be accompanied or preceded by a falling dollar from today’s extreme heights.

While none of this would be particularly inspiring for American households or businesses, it could amount to a very good environment for financial assets which thrived in the slow-growth, low-inflation, low-interest rate world which prevailed in the decade before the pandemic. 

[1] See Monthly Budget Review, September 2022, Congressional Budget Office, October 11th, 2022.

For more of my insights, listen to my Insights Now podcast for a breakdown on big ideas, future trends and their investment implications.

Disclaimers

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

Content is intended for institutional/wholesale/professional clients and qualified investors only (not for retail investors) as defined by local laws and regulations. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide (collectively “JPM”).

Opinions and comments may not reflect those of J.P. Morgan or its affiliates. Content is intended for US audience only, and should not be considered a recommendation or endorsement by JPM for any product, service or strategy specific to any individual investor’s needs. JPM is not responsible for third-party posted content. "Likes", "Favorites", shares, similar functionality or content appearing on third party websites should not be considered an endorsement of JPM products or services.”).