The Federal Open Market Committee delayed the initial reduction in the pace of its asset purchases, citing concern about the recent tightening of financial conditions (higher long-term interest rates). However, Bernanke also noted uncertainty in fiscal policy. He recognized the improvement in economic activity and labor market conditions since the Fed began QE3, which was achieved in spite of a federal fiscal retrenchment. He also suggested that the debates on the government’s spending and borrowing authorities may create downside risks.
The focus on the large federal budget deficits of recent years has been misplaced. The large deficits were driven largely by the recession. Tax revenues fell sharply as the economy slowed. Recession-related spending increased. Revenues are improving as the economy recovers. Spending is down two fiscal years in a row. Yes, you heard that right, spending has fallen over the last two years. Spending is currently below where it was projected to be before Obama was even nominated for president.
Debates over the appropriate size and function of the government are nothing new, but these are largely political issues, not economic ones. However, fiscal policy does matters. Efforts to reduce the deficit have slowed the recovery considerably this year. Economic growth is still at a moderate pace, more or less, but the expansion would have picked up a lot more steam if fiscal policy hadn’t been tightened (real GDP growth of 3.5% to 4.0%, vs. the 2.0% to 2.5% we’re likely to see).
Many people fear that the government’s borrowing costs will rise as interest rates begin to normalize. Well, that’s right. In its budget projections, the Congressional Budget Office assumes that interest rates will increase significantly in the years ahead. The government’s interest payments will rise sharply as a percentage of GDP, accounting for nearly all of the projected budget deficits over the next several years.
As a percentage of GDP, discretionary spending is set to decline in the years ahead. Mandatory spending (Social Security, Medicare) will account for a larger share of spending as the population ages. Moreover, Medicare expenditures are set to rise more sharply in the next few decades. Projections suggest that we are on an unsustainable track. However, legislative efforts, while slowing the pace of recovery this year, have also made the longer-term outlook worse.
The battle over the budget and debt ceiling are expected to be contentious. Lawmakers should be able to come up with a series of short-term Continuing Resolutions while a long-term budget agreement is worked out. A government shutdown would not defund the Affordable Care Act (which is considered an entitlement, not discretionary spending). The debate over the debt ceiling is more critical, as a default would likely contribute to a broader financial crisis. The financial markets are relatively complacent, believing that everything will be worked out, but the downside risks are considerable.
© Raymond James