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October 13, 2023 | 13:43
America’s Fiscal Follies
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Fixed Income Strategy
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America’s Fiscal Follies |
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Late last month, as politicians clashed in trying to pass a continuing resolution that would prevent a government shutdown on October 1, Moody’s weighed into the debate. It said that a shutdown would be a credit-negative development that could eventually contribute to a rating downgrade (currently, Moody’s rates the U.S. as Aaa with a stable outlook). This was a profound statement given that a shutdown would not interrupt the timeliness of Treasury’s principal and interest payments, unlike what could occur if the debt limit isn’t lifted or suspended. Amid pressures posed by potentially higher-for-longer interest rates along with an already massive and mounting debt burden, Moody’s said “it’s that much more important that fiscal policy can respond” to these pressures. However, fiscal policymaking “looks increasingly challenged because of things like the government shutdown and having come off the debt limit episode, because it’s such a polarized political dynamic in Washington”. The warning by Moody’s followed the announcement by Fitch on August 1 that it had downgraded the U.S. credit rating to AA+ from AAA. That action occurred after the agency had put the U.S. on Rating Watch Negative in May as politicians were again clashing in trying to pass legislation that would lift the debt limit and avoid a default. And it occurred despite the Fiscal Responsibility Act of 2023 being signed into law on June 2, which included $1.5 trillion in 10-year deficit reduction along with suspending the debt ceiling until January 2025. Apart from still-deteriorating deficit and debt dynamics, Fitch said the downgrade reflects the “steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters” and that “the repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management”. It’s interesting that Fitch’s downgrade was announced almost on the same day that S&P announced its downgrade 12 years earlier (also to AA+ from AAA on August 5, 2011). Indeed, what S&P concluded more than a decade ago is as relevant today as it was then. Meaningful fiscal consolidation “is less likely than we previously assumed and will remain a contentious and fitful process”. Moreover, “the political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed.” Since that assessment, gross federal debt (the aggregate limited by the debt ceiling) increased from more than 95% of GDP (in 2011) to around 122% in the fiscal year ended last month. The faster-expanding part held by the public, that financial markets focus on more because it represents marketable securities, jumped from just over 65% to around 97%. Given this history, along with the deficit and debt profiles projected to unfold during the decade ahead, we reckon America’s next credit rating downgrade won’t be waiting for another dozen years. The profiles are described below. Deficits running higher, debt growing bigger |
The CBO’s baseline deficit projection was published in May 2023, based on all information (and legislation enacted) as of March 30. An adjusted baseline was estimated in June (Chart 1), incorporating the impact of the Fiscal Responsibility Act (FRA). As mentioned above, the FRA pared the 10-year year deficit by $1.52 trillion (or by 7.5%), including by $70 billion in the current fiscal year (starting October 1) and $112 billion in fiscal 2025. The budget shortfall is still projected at $1.50 trillion this year and $1.65 trillion next year and continues trending higher in later years. As a percentage of GDP, the deficit is pegged at 5.5% and 5.7%, respectively, for this fiscal year and next. It stays mostly in the 5% range during the forecast horizon with the final two years above 6%. The interval average is 5.7%, which is a full percentage point above the mean that stabilizes gross federal debt at 2023’s 122% of GDP over the coming decade. |
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For fiscal 2023, which ended last month, budget figures for September have not yet been released. However, the CBO estimates the monthly shortfall at $166 billion, resulting in a full-year deficit of $1.69 trillion. This is above the original $1.53 trillion baseline and the $1.38 trillion budget shortfall for fiscal 2022. The 2022 figure deteriorated from the cost of cancelling student debt ($379 billion) and the 2023 number improved after accounting for its court-ordered reversal ($333 billion). (The Administration is planning on keeping some student debt cancellations under alternative programs.) If not for the student debt cancellation kerfuffle (and adjusting for the timing of outlays when October 1 falls on a weekend), the deficit would have doubled from around $0.9 trillion in fiscal 2022 to about $2.0 trillion in 2023, reflecting mostly the mix of lower receipts (by $455 billion), larger mandatory outlays (by $285 billion) and higher interest on the public debt (by $177 billion). The CBO’s $400 billion ‘miss’ on projected receipts reflected lower capital gains taxes, larger claims of the (pandemic-related) Employee Retention Tax Credit and the postponed filing deadline for taxpayers affected by natural disasters (such as in California). It’s unclear to what extent these receipts issues will persist and, thus, what will be the impact of a $2.0 trillion deficit handoff for this fiscal year. One thing is clear, however; larger interest outlays will likely be here to stay reflecting the combination of higher (for longer?) interest rates and rising debt. Given the CBO’s baseline forecast for budget deficits, gross federal debt held by the public is expected to continue trending higher (Chart 2). It should surpass the 100% of GDP mark next fiscal year and establish a new record high of 106.6% in 2029. The earlier record was 106.1% hit in 1946, in the aftermath of WWII. Even if interest rates don’t increase, growing debt would result in rising interest payments—but rates are increasing. |
In September, the average interest rate on marketable Treasury debt was 3.02%, nudging above the 3% mark for the first rime since January 2009 and more than double the record low of 1.42% in January 2022 (Chart 3). The CBO estimates interest payments totalled $711 billion last fiscal year and the aggregate amount is expected to keep increasing over the next decade. This explains part of the uptrend in the budget deficit. Interest payments are projected to top $1 trillion in 2029 and hit a record-high share of receipts (above 18.4%) in 2031 (Chart 4). Rising interest outlays are going to increasingly constrain fiscal policy flexibility, which has always been mentioned by the CBO (and others) as one of the major negative consequences of a large and growing government debt burden. As emphasized above, the credit rating agencies’ greatest angst has been about the dysfunctionality of the fiscal policymaking process. This is because, against the background of already steadily rising deficits and growing debt, there are major policy decisions to be made in the years ahead that risk making the situation even worse. For example, the CBO projections assume that the 2017 personal tax cuts sunset at the end of 2025 as per existing legislation. Will the politicians allow this to occur; or, will they extend them or make them permanent, which will increase subsequent deficits? (History points to the latter.) Also, the latest trustees’ reports released in March showed that the trust fund for Social Security will be exhausted in 2033 with Medicare running dry in 2031. When the surpluses run out, this shifts the residual funding of the programs and the subsequent growth in these mandatory outlays to the budget’s bottom line (i.e., it adds directly to the deficit), unless the politicians find a way to increase individual and business contribution rates and/or pare back benefits. Even if we make it past November 17, when the current continuing resolution expires, without a government shutdown, is it any wonder why the rating agencies are so worried? |
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