Introduction:
The recent deal to raise the federal debt limit in Washington includes a spending cap on government expenditure. While this agreement averts the risk of a financial collapse triggered by a default, it introduces new challenges for the US economy. With already high interest rates and restricted access to credit, the spending cap could potentially dampen economic growth, adding to concerns about a possible downturn. This article explores the potential consequences of the spending cap on the US economy, its implications for monetary policy, and the outlook for inflation and employment.
- The Effect on Economic Growth:
Federal spending has played a crucial role in supporting US growth amid challenges such as a decline in residential construction. The spending cap is expected to diminish this stimulus, possibly impacting economic growth. Economists had previously estimated a 65% chance of a recession in the coming year, which could be amplified by reduced fiscal spending. The spending limits, set to be applied from October 1st, could have minor effects before then, such as the clawback of Covid assistance and the phasing out of student debt forbearance.
- Monetary Policy and Interest Rates:
The spending cap presents a new consideration for Federal Reserve policymakers as they reassess growth projections and the benchmark interest rate. With the economy facing restrictive monetary policy and potentially more to come, the fiscal policy tightening will amplify the existing headwinds. Futures traders currently predict no change in interest rates at the mid-June policy meeting, but anticipate a 25 basis-point hike in July. The convergence of fiscal and monetary policies moving in reverse could have far-reaching consequences for the economy.
- Stock Market and Treasury Yields:
US stock futures saw a slight increase in Monday morning trading in Asia, indicating a positive market sentiment. However, the Memorial Day holiday halted Treasuries trading, although 10-year Treasury futures experienced a small decline. This decline led to a slightly higher implied yield of 4.46%. The market response to the spending cap and its potential impact on the economy will be closely monitored.
- Employment and Inflation:
Economists highlight the significance of fiscal multipliers during a recession. If the US enters a downturn, reduced fiscal spending could have a more substantial impact on GDP and employment. Despite these concerns, major financial institutions, such as JPMorgan Chase & Co., maintain their base case scenario of the US avoiding a recession. The combined effect of fiscal and monetary policy could help manage inflation levels. With historically high demand for workers and excess savings from the pandemic, the economy has demonstrated resilience.
- Long-term Implications:
While the spending cap aims to control government expenditure, it is unlikely to alter the trajectory of federal debt significantly. The International Monetary Fund (IMF) suggests that the US needs to tighten its primary budget by around 5% of GDP to achieve a sustained reduction in public debt by the end of the decade. Keeping spending at 2023 levels falls short of such substantial restraint. Analysts note that the two-year spending caps may not pose significant fiscal headwinds or significantly reduce deficits.
Conclusion:
The spending cap included in the recent debt limit deal in Washington introduces additional challenges to an already burdened US economy. With high interest rates and restricted credit access, the reduced fiscal spending may dampen economic growth, potentially contributing to a downturn. Federal Reserve policymakers must consider the impact of the spending cap on their growth projections and interest rate decisions. However, the combined efforts of fiscal and monetary policy could help manage inflation levels. While the spending cap falls short of major long-term debt restraint, its immediate consequences will be observed as the economy adapts to these changes.
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