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Lower taxes voted in at the end of 2017 were already set to raise the budget deficit by about 1 percentage point of GDP in 2019, and the spending bill passed by Congress early February will push it even higher – to levels unseen in US peacetime and outside recession. The bipartisan Democrat and Republican agreement will end a spell during which the government was financed for only weeks or months at a time and had to operate with the risk of shutdowns, i.e. when federal entities halted ‘non-essential’ business. This was the case on 20–22 January and on 9 February for several hours until President Trump signed the agreement.
The bill raises the spending cap by $143 billion for fiscal year 2018 and by $153 billion for fiscal year 2019, and adds over $80 billion to fund rebuilding following the 2017 autumn hurricanes. Deficit reduction measures amounting to about $100 billion have been taken, although some might only be one-off, such as selling some of the country’s strategic oil reserves. The debt ceiling has been suspended until 1 March 2019. A full budget considering these elements will be voted by 23 March.
Never before has fiscal stimulus of this size been undertaken at this stage of an economic cycle. Rough ‘guesstimates’ suggest the budget deficit will exceed 5% for fiscal year 2019, a record high during US peacetime, outside recession, and with historically low unemployment. While the short-term impact of lower taxes on the economy is relatively uncertain, the same cannot be said of increases in government expenditure. The measures boost the likelihood of stronger domestic demand in the quarters ahead, but also beg numerous questions. First, in a full, or almost full, employment economy, will stronger levels of domestic demand result in an increase in supply, and thus in production? If the answer is no, then the trade balance could deteriorate and weaken the dollar. Such concerns have likely contributed to recent currency weakness.
Second, how will the Federal Reserve react? Will the Fed seek to dampen the fiscal stimulus by raising policy rates faster? Some answers may come on 28 February, when Fed president Jerome Powell submits the six-month monetary policy report to Congress, and on 21 March, when the central bank’s updated forecasts are published.
In final, the rise in the deficit comes at a time when spending due to population ageing is liable to increase and thus create upward pressure in the years ahead. Will the US government have any fiscal leeway left when the cycle downturns again? Could the sustainability of US debt be called into question? In short, the recent fiscal decisions have created a deep sense of uncertainty.
The opinion expressed above is dated 15 February 2018 and is liable to change.
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