Viewpoint
May 23, 2025 | 15:44
May 23, 2025
Economics
Economics
Economics
Economics
Economics
Economics
Muddling Through for the Moment |
| While we didn’t receive a lot of first-tier economic indicators this week, what we did see tells us something about where the economy is right now. We’re still muddling through for the moment. This was illustrated by the Chicago Fed’s National Activity Index for April—a weighted average of 85 economic indicators—where zero suggests the national economy was expanding at its historical trend rate of growth. The reciprocal tariffs were first announced on April 2, so this number represents the first (nearly) full month of severe tariff uncertainty. Notably, the index came in at -0.25 in April, suggesting economic growth was a bit below average last month, but not shockingly so (Chart 1). In fact, the index was just as negative in January and was even lower back in October and January of last year. Indeed, the three-month average remained modestly positive, implying somewhat faster-than-average economic growth. |
| U.S. economic surprise indexes paint a similar picture, corroborating the evidence above and implying only a modest economic underperformance compared to projections. The Bloomberg Economic Surprise Index was just slightly negative at -0.11, implying only mildly negative economic surprises on net so far. It seems the momentum may be carrying on into May. Notice in Chart 2, economic surprises were much more negative last summer, when recession fears were rising and before the Fed started cutting interest rates in September. Moreover, the split between the hard and soft data continues. We see persistent positive, though diminishing, surprises coming from the ‘hard’ economic indicators and persistent negative, though improving, surprises coming from the ‘soft’ sentiment and survey data (Chart 3). Right on cue, the preliminary S&P Global PMI indexes for manufacturers and service businesses unexpectedly rebounded to 52.3 in May (Chart 4). For manufacturers, it was the best showing since February; and for services, it was the highest reading since March. This suggests the tariff truce we got last week between the U.S. and China and the sharp rebound in equity prices may be having its intended effect of at least temporarily bolstering producer and consumer sentiment. Next week’s economic indicators, like Tuesday’s Conference Board Consumer Confidence Index and Dallas Fed Manufacturing Index—which are both forecast to improve modestly in May—will more thoroughly test this theory. The problem for the Fed is this feat of economic levitation could still prove fleeting as the still-substantial level of average tariffs starts pushing up consumer prices, denting domestic demand and business profits. Also, firmer near-term economic data will likely keep the Fed on hold for longer as it awaits clearer signs of how the tariffs are impacting overall inflation and inflation expectations. Longer-term Treasury yields and mortgage interest rates have already been rising on market expectations of fewer Fed rate cuts this year and higher inflation expectations. The House passage of its “One Big Beautiful Bill”, and the higher budget deficits it will likely bring over the next 10 years, will only aggravate these unfavorable interest rate trends—further complicating the Fed’s task of maintaining full employment and stable prices. |
Fiscal Update: Strike ThreeAmerica’s fiscal picture is bad and if the House-passed One Big Beautiful Bill is any guide, it’s about to get worse. Moody’s has taken note. |
| On May 16, Moody’s Ratings downgraded the U.S. Government from Aaa to Aa1, the last of the ‘big 3’ credit rating agencies to strip America of its ‘triple A’ status. Fitch Ratings did it in August 2023 following S&P Global Ratings' move back in August 2011. Moody’s said: “Successive U.S. administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs.” And, looking at current budget talks, “we do not believe that material multi-year reductions in mandatory spending and deficits will result”. In consequence, “over the next decade, we expect larger deficits as entitlement spending rises while government revenue remains broadly flat” and that this “will drive the government’s debt and interest burden higher”. The downgrade follows Moody’s move in November 2023 to dim America’s ratings outlook from stable to negative. At the time, we were in the wake of another down-to-the-wire budget deal that addressed the debt limit within days of ‘X-date’ (the point when Treasury no longer has enough cash to pay all its bills). The Fiscal Responsibility Act, signed by President Biden in June 2023, cut or capped some spending and suspended the debt ceiling until January 1, 2025. Moody’s was not impressed by the degree of spending restraint (“fiscal deficits will remain very large, significantly weakening debt affordability”), and neither were some GOP members (it cost then-House Speaker McCarthy his job). Moody’s was also not impressed with the brinkmanship (“continued political polarization within US Congress raises the risk that successive governments will not be able to reach consensus on a fiscal plan to slow the decline in debt affordability”). Although the brinkmanship of a divided Congress is no longer present, it has been replaced (at least partly) by the Republicans’ intra-party squabbling. And the GOP’s Senate attempt to depart from standard budgeting practice to ‘hide’ the fiscal consequences of extending the expiring 2017 tax cuts is a concern. We suspect these policy-impinging political considerations influenced Moody’s downgrade decision, as they had done at the time of Fitch’s and S&P’s downgrades. Fitch argued: “The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.” A dozen years earlier, S&P stated that “the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.” S&P’s assessment appears as relevant today as it did 14 years ago. The fiscal pictureCentral to Moody’s downgrade decision was the conclusion: “The US’ fiscal performance is likely to deteriorate relative to its own past and compared to other highly-rated sovereigns.” The fiscal situation on the ground now is already bad enough to warrant stripping ‘triple A’ status, and it’s only expected to get worse. |
| The Congressional Budget Office (CBO) released its latest 10-year projection in January, based on legislation enacted through January 6, 2025, which was two weeks before Inauguration Day. The deficit for the current fiscal year (ending September 30, 2025) was estimated at $1.87 trillion, or 6.2% of GDP (Chart 1). This represented a slight deterioration from $1.83 trillion in fiscal 2024, but the monthly figures are pointing to even further deterioration. Through the seven months ending April 2025, the cumulative deficit is $1.05 trillion, $194 billion above where it stood after seven months last fiscal year and pointing to a full 2025 figure topping $2.0 trillion. (For the record, the latest 12-month moving tally is $2.03 trillion). |
The CBO’s baseline projection showed the deficit improving to $1.71 trillion in fiscal 2026 (5.5% of GDP) and $1.69 trillion in 2027 (5.2%) partly owing to the expiration of the 2017 tax cuts. Then it trended larger again (as high as in the $2.5-to-$2.6 trillion range in the final few years) and averaged near 6% of GDP through 2035. However, the tax cuts won’t be expiring after December 31, 2025, and budget shortfalls won’t be ebbing to begin the next decade—they’ll likely be mounting. The House of Representatives passed the One Big Beautiful Bill Act (OBBBA) on May 22, squeaking by with a vote of 215-to-214. (Given the official party standings—220 Republicans, 212 Democrats, 3 vacant—this meant that 2 GOP members voted against it and 3 voted ‘present’ or were absent.) The OBBBA extends the expiring 2017 tax cuts with a 10-year cost of $4.13 trillion, according to the Committee for a Responsible Federal Budget (CRFB, which in line with what the CBO had estimated). But there’s more. The tax cuts promised during the election, such as for factories and seniors (along with no taxes on tips, overtime pay, and auto loans), were included with a wrinkle. They all expire at the end of 2028. This limits their combined 10-year cost to ‘only’ $442 billion. And it sets up a looming ‘fiscal cliff’ in time for the 2028 presidential election. The Administration’s spending priorities showed up as well, including increased funding for border security and the ‘wall’, deportations capacity and defense (the biggest chunks going to shipbuilding along with air superiority and missile defense). These tax and spending measures are partly offset by items such as repealing or phasing out the Inflation Reduction Act (IRA) and other Biden-era tax credits (saving $559 billion over 10 years), reducing Medicaid funding ($446 billion), reforming student loan programs ($346 billion), and cutting funding for food security ($225 billion). But, on balance, the 10-year budget deficit is still projected to jump by $2.5 trillion according to the CRFB, with some front-loading owing to the slew of new tax cuts. Including the interest on the (new) debt, the additional budget shortfall weighs in at around $3.1 trillion over the next decade. However, there's no accounting for tariff revenue here, which has the potential to put a big dent in this amount. For example, a 10% average tariff on total goods imports could generate more than $325 billion per year, other things equal (which they won't be). |
| The budget baton now passes to the Senate, with its proclivity to keep deficits as small as practical (hence, the past effort to ‘hide’ the impact of extending the expiring tax cuts). Note that even before the CBO formally scores the full OBBBA and produces an adjusted baseline, the debt and interest dynamics are already worrisome (and recall the current forecast incorporated the expiring 2017 tax cuts doing just that). Gross federal debt held by the public will top 100% of GDP as this year unfolds (above $30.1 trillion) and is on track to surpass the World War II-era record highs within three years’ time (Chart 2). By 2035, total debt (including that held by the dwindling Social Security and Medicare Trust Funds) will top $59 trillion or almost 135% of GDP. This rising debt combines with higher interest rates to cause debt service costs to soar. Interest payments will hit almost a record $1 trillion this year (3.6% of GDP) and are projected to climb to $1.8 trillion (4.1%) by FY2035 (Chart 3). Indeed, most of the trend deterioration in the deficit over the coming decade is due to increasing interest payments, with a bit at the end of the interval owing to the insolvency of the above-mentioned trust funds. Insolvency means current and accumulated surplus contributions no longer cover benefit payments, and the residual funding of these mandatory outlays adds directly to the deficit. The Senate is very unlikely to rubber stamp the House’s budget bill, so stay tuned for more deficit drama. The GOP-led Congress has given itself a July 4 deadline to deliver a common bill for the president to sign. And there’s another countdown clock ticking. The debt limit was re-established on January 1. Treasury had a starting balance of $722 billion in its bank account at the Fed, and it has employed ‘extraordinary measures’ to free up some room for a little more marketable borrowing (Chart 4). In the wake of the April 15 tax deadline, on May 6, Treasury Secretary Bessent sent a letter to congressional leaders advising that ‘X-date’ could arrive sometime in August, when Congress will be on summer recess. He implored Congress to address the debt ceiling by mid-July. This, too, is expected to be rolled into the One Big Beautiful Bill. |
