June 02, 2023 | 13:53
Debt Deal Done
Debt Deal Done
President Biden signed the Fiscal Responsibility Act of 2023 (FRA) into law on June 2. With a June 5 ‘X-Date’ looming, or when the U.S. government would no longer be able to honour all its financial obligations (and thus potentially default), President Biden and Speaker McCarthy announced a compromise deal on May 27. It landed between the Administration’s original ‘no negotiation’ stance and the House-passed bill with much more draconian measures, and quickly made its way through the legislative process. The bill passed the Republican-controlled House of Representatives on May 31, in a bipartisan fashion, via a 314-to-117 vote (after a tighter 7-to-6 result in the Rules Committee). It passed the Democrat-controlled Senate by a 63-to-36 tally on June 1, in a similar bipartisan fashion. Now, we don’t have to worry about X-Dates for two years.
Suspension and sequestration
The FRA suspends the debt limit until January 2, 2025 (Chart 1). The limit will be reinstated at the level of debt outstanding on January 1, with a prohibition against building up a “cash balance above normal operating balances in anticipation”. “Normal” isn’t defined but, at this juncture, extraordinary measures and cash balance drawdowns will once again be relied upon to fund the fiscal shortfall before a new X-Date, unless the debt limit is lifted or suspended again.
The FRA caps base funding (or budget authority) for discretionary spending at $1,590 billion in fiscal 2024, $36 billion below the amount enacted for this year and $110 billion below the level estimated by the CBO for next year (based on their usual assumption matching their inflation call) (Table 1). In both comparisons, all the adjustment occurs on the non-defense side. (For the remainder of the report, all references to years are fiscal years that end in September.)
The White House is emphasizing that including “agreed-upon appropriations adjustments”, such as repurposing some of last year’s multiyear funding to the IRS for increased enforcement along with remaining COVID relief budget authority, funding for next year's non-defense discretionary programs is “roughly flat” to this year. The growth in base funding is then capped at 1% for 2025, keeping the level below this year’s and even further below the CBO’s projection for the period.
The caps have ‘teeth’ in the sense that if Congress fails to enact full-year appropriations of these amounts by January 1, broad-based 1% sequestered spending cuts kick in. The legislation also mentions 1% growth caps for the 2026-2029 interval, but these aren’t enforced by prospective sequestration.
Note that actual spending each year tends to deviate from contemporaneous budget authority. For example, the former could be larger, reflecting outlays authorized from previous years or those resulting from ‘non-base’ funding for things like disaster relief. Or, the latter could be larger owing to one-time multiyear base funding. For example, discretionary spending in 2022 was $1,659 billion with $1,601 billion being authorized in that year. And, it’s actual spending that matters for the budget deficit and the economy.
Deficits and debt
The two-year caps on budget authority will cut the expected growth in discretionary spending by almost half, according to the CBO (Chart 2). In 2024, discretionary outlays will increase 4.1%, down deeply from 7.8% in the current baseline, for a reduction of $64 billion. In 2025, the 2.9% growth rate is also down steeply from the baseline’s 5.1%, for a reduction of $107 billion.
With subsequent spending caps unenforceable, the before- and after-FRA spending profiles converge after a few years. The 10-year reduction in aggregate discretionary outlays amounts to $1,332 billion. The CBO also considers the case in which the 1% caps over the 2026-to-2029 interval are binding. This continues to dampen the spending profile until growth slows to just 0.7% in 2029, for a 10-year total of $1,883 billion.
The reduction in discretionary spending reduces the budget deficit. The profile for deficits is dampened further (over time) by lower interest on the public debt (Chart 3). The 10-year reduction in the accumulated budget deficit is $1,528 billion.
So, this deal to lift the debt limit will result in the debt being $1.5 trillion lower than it otherwise would have been by 2033 (Chart 4). The debt ratio is reduced to 115% of GDP instead of 118.9% in the CBO baseline. Apart from 1945 and 1946 (WWII-related), the ratio has never topped 100%. Following the 20-percentage-point vault in 2020 (owing to the pandemic and the policy response to it), and, since 2022, the stubborn run of large budget shortfalls roughly around $1.5 trillion, debt should top 100% next year. The FRA only manages to delay surpassing the record-high debt ratio (106.1% of GDP in 1946) by a year, now in 2029 instead of 2028.
The lack of a more meaningful dent in the debt profile emphasizes a fundamental issue in America’s deficit and debt dynamics. For 2023, discretionary spending runs around 27% of total outlays, with mandatory spending (63%) and net interest (10%) accounting for the rest. Given the demographic pressure on mandatory outlays like Social Security and Medicare, and the consequences of record debt levels being financed by non-emergency levels of interest rates, discretionary spending will be shouldering more of the burden of keeping total outlays in check. Adding revenues and outlays together, discretionary spending weighs in at just 15% of total budgetary resources available to address unsustainable deficits and debt levels. Faster growth in revenues and slower growth in mandatory spending are required as well, particularly if (discretionary) government services and programs are to be maintained.
Economy and Fed policy
Because of the FRA, discretionary outlays will be lower than they otherwise would have been, and the economy will get less of a boost from federal government spending. Recall for 2024, the growth in discretionary outlays will be clipped by 3.7 percentage points to 4.1%, which is worth $64 billion or about 0.2% of GDP. But we reckon that this will merely rein in the ‘extra’ boost discretionary spending was going to be giving economic growth.
We’re expecting CPI inflation to average 2.8% in 2024 (2.5% for the calendar year), real GDP growth to average 0.6% (1.0% for the calendar year) and nominal GDP growth to average 3.3% (same for the calendar year). So, a 4.1% gain in discretionary spending will still be positive in real terms and will punch above its weight in contributions to economic growth. Importantly, compared to the baseline’s near-8% nominal gain, this should contribute to more favourable inflation performance (other things equal).
For the Federal Reserve, this is a situation that starts unfolding in October but will still take some time to become meaningful. In other words, it’s probably not going to matter much for monetary policy during the remainder of this year. However, ending the politicians’ debt-limit drama could still have policy implications, if only from a technical perspective.
Treasury is going to have to replenish its cash balance and reverse the extraordinary measures, which means expedited net debt issuance, particularly for T-bills (at least initially). As of May 31, Treasury had $49 billion left in its bank account at the Fed (Chart 5). During calendar 2022 (recall the debt limit was hit in January 2023), the daily cash balance averaged $630 billion. The impending net T-bill issuance could apply upward pressure on T-bill yields and other money market rates.
Meanwhile, there’s currently $2.6 trillion of mostly institutional investor money parked in the Fed’s overnight reverse repo facility (a Fed liability). Presumably some of this will shift into soon-to-be more available and potentially more attractive T-bills. To the extent it doesn’t, against the background of the Fed continuing with quantitative tightening (QT) and reducing the size of its balance sheet (all liabilities), increases in Treasury’s cash balance (a liability) will be reflected in decreases in bank reserves (a liability). This could apply pressure in the overnight lending market (fed funds, SOFR), perhaps even causing a temporary technical adjustment to QT. The Fed’s debt limit drama isn’t done yet.