The real reason to worry about the US deficit

In a week of breathless headlines (Brexit, Italy and Brexit again…) last Monday’s news that the US budget deficit widened to a six-year high of $779bn in the fiscal year ending September 30^th crept under the radar. As a share of GDP, the deficit is now running at 3.9%, up from 3.5% in 2017-18.

The increase in the deficit stands out because the US economy is running at full employment and growth is humming along at a decent pace. This is the time when the so-called “automatic stabilisers” in fiscal policy should cause the deficit to narrow, as tax receipts grow and government outlays on unemployment benefits and the like diminish. The problem in the US, of course, is that the effects of the normal fiscal stabilisers have been dwarfed by a combination of additional spending on defence and the large cuts in tax approved by Congress at the end of last year.

There are plenty of reasons to think that large-scale stimulus this late in the cycle will prove to be a mistake (I’ll come back to this later). But I don’t adhere to the idea, which is often put to us, that the bond markets have somehow been remiss in not “punishing” the US government for loosening policy. Admittedly, 10-year bond yields have risen by more than 1%-pt over the past year. But there is an argument out there that this is insufficient to compensate investors for the huge increase in the supply of bonds that has resulted from the fiscal loosening – and thus a sharp spike in yields is just around the corner.

An alternative way to approach this, however, is to think of bond yields as being a function of two things: the expected path of short-term interest rates and a “term premium” that captures everything else, including credit risk. Viewed this way, there are two reasons why bond yields may rise in response to a fiscal stimulus. The first is if monetary policy has to tighten in order to offset the expansionary and inflationary effects of looser fiscal policy (thus pushing up the expected path of short-term interest rates). And the second is if the market perceives that the fiscal stimulus has worsened the supply/demand balance and at the margin increased the risk of default (thus pushing up the term premium).

In the case of the US, we have seen the expected path of short term interest rates shift up as investors have anticipated that the Fed will counter the inflationary effects of fiscal stimulus by tightening monetary policy. But the term premium component of bond yields has remained lodged below zero. (See Chart.) In other words, all of the rise in yields over the past year has been driven by an increase in the expected path of short-term rates – and there’s no evidence that the deterioration in the budget position is causing investors to demand a higher premium for holding US sovereign debt.

Chart: Breakdown of 10-year US Treasury Yield (%-pts)

There are several reasons why this might be justified. For a start, the low level of bond yields elsewhere in the world means that demand for still relatively risk-free US debt securities has remained high. What’s more, a fall in the outstanding stock of domestic municipal securities, mortgage-backed securities and financial sector corporate bonds means that, despite a rise in the supply in US government bonds, the overall pool of dollar debt securities available to investors has remained broadly flat as a share of GDP over the past decade. Finally, and more fundamentally, all of the US government’s debt is denominated in dollars, and there are almost no examples of governments defaulting on local debt. Accordingly, bond markets tend to tolerate fiscal indiscipline for far longer than would otherwise the case. (The contrast with Italy is striking, and we continue to believe it’s a fiscal accident waiting to happen).

The key point, then, is that there is no reason to think that a surge in the supply of Treasuries will automatically push up yields. Instead, we expect that over the next couple of years yields will continue to take their cue from shifts in monetary policy – and as we argued in our latest Global Markets Outlook, published last week, there are good reasons to think that they are now close to peaking.

Given this, why might fiscal stimulus this late in the cycle prove to be a mistake? Two points stand out. First, as we argued in a US Economics Focus last week, even if the risk of an imminent fiscal crunch is low, the long-term fiscal trajectory is unsustainable. Trump’s stimulus has increased the scale of the challenge that will be faced by a future government – and the risk that the bond market ultimately forces its hand.

More immediately, the deterioration in the budget position limits the scope for a fiscal response to the next downturn. As I argued in my note last week, we expect America’s economy to undergo a sharp slowdown in 2019. And if that’s the case, it will enter the next downturn with a federal budget deficit of over 4% of GDP and net government debt pushing 90% of GDP. Given the exorbitant privilege afforded to the US as the world’s reserve currency, I’d be fairly confident that the bond market would still tolerate another fiscal expansion in the event of an economic slowdown. But I’d be more worried about political opposition to another round of stimulus from this starting point. All of this reinforces a point we’ve made before – that policymakers are likely to find themselves with less ammunition to deal with the next downturn.