More Clarity and Less Stimulus from Washington

The week ahead will, of course, be dominated by Thanksgiving, leading, appropriately, to less focus on financial markets.? That being said, this should also be a week of greater clarity on fiscal and monetary policy.? This clarity should reinforce the view that Washington aid will become considerably less generous in the year ahead, reducing inflation fears but posing some threat to recently very strong profit growth.

On Thursday, the Congressional Budget Office produced its long-awaited score of the House version of the reconciliation bill.? This enabled Democrats to pass the bill on Friday by a vote of 220 to 213, sending it to the Senate.? While the Senate will undoubtedly modify the bill, House passage increases the likelihood of something roughly similar being signed into law by the President in December, simultaneously eliminating the risk of a government shutdown or debt-ceiling crisis.

The diminished risk of a fiscal crisis is important to financial markets but so are the overall fiscal impacts of the bill.??

On this issue, it is clear that fiscal stimulus is winding down fast.? The federal government’s fiscal year ends on September 30th.? In fiscal 2020, the federal budget deficit amounted to $3.132 trillion or 15.0% of GDP.? This fell to $2.772 trillion or 12.4% of GDP last year.?

In July, the Congressional Budget Office estimated that, without any further legislation, the deficit would fall to $1.153 trillion or 4.7% of GDP in the current fiscal year.? Much of the money allocated in the infrastructure bill passed earlier this month was already built into CBO projections so the net impact of that legislation would have been to subtract $4 billion from the deficit in the current fiscal year and to add $256 billion to cumulative deficits between now and 2031.

The reconciliation bill passed by the House also has relatively modest impacts on the deficit, boosting it by $155 billion in the current fiscal year and $367 billion between now and 2031, before accounting for extra revenue from enhanced IRS enforcement.?

Adding the impact of these two bills to the CBO’s July forecast and making adjustments for CBO errors in forecasting both the fiscal 2021 deficit and fiscal 2021 GDP, suggest a deficit of $1,188 billion or 4.8% of GDP this fiscal year and $844 billion or 3.3% of GDP in fiscal 2023.

This is, of course, a massive drop in fiscal stimulus and may well be appropriate for an economy suffering from inflation pressures and heading towards full employment.? However, it does suggest that, after a surge in economic activity over the next few months, both economic growth and inflation should slow in the second half of next year.? Finally, it should be noted that, while future legislation could boost deficits in the out years, a Republican takeover of the Senate or the House or both in the mid-term elections could keep a lid on any further net fiscal stimulus between now and 2025.

Less fiscal stimulus should also impact monetary policy going forward.

This morning, the President renominated Jay Powell for a second term as Fed Chair, in a move which made sense from both a political and policy perspective. Chairman Powell was appointed by a Republican President and his renomination allows President Biden to boost his credentials as a political moderate.? Moreover, if something goes wrong with the markets or the economy in the months ahead, Republicans won’t be able to point to his Fed pick as the reason.? In addition, Chair Powell has proven to be a skilled and empathetic communicator, has been effective at managing financial conditions throughout the pandemic, and had the support of Treasury Secretary Yellen.

In the same White House statement, the President also nominated Governor Lael Brainard to be Fed Vice-Chair replacing Richard Clarida, whose term comes to an end in January.? In addition, the President intends to nominate people to fill the now three vacant seats on the Fed Board of Governors by early December.

These personnel changes could be significant for policy since the President is unlikely to nominate overtly hawkish governors.? This suggests that the current dovish tilt within the Board of Governors will be maintained in 2022 and could offset a slightly more hawkish group of regional Fed bank presidents who will gain FOMC voting rights in January.

The net effect of the President’s Fed changes should reinforce the idea that the Fed will be cautious about tightening policy too abruptly.? As of this morning, the fed funds futures market is pricing in one Fed rate hike by August, a second by November and the possibility of a third by the end of the year.?

Given the very cautious approach towards tightening adopted by the Fed in recent years, this seems like a very aggressive schedule.? By the middle of 2022, inflation should be falling, growth should be slowing, fiscal stimulus should be waning and the political temperature will be rising.? In addition, by that point, the Fed should have ended its bond-buying program, putting some upward pressure on long-term interest rates.

Given all of this, it still seems more likely than not that the Fed will wait until December 2022 before raising short-term interest rates.? If this transpires, then investors can hope for a more extended, although slow economic expansion, allowing for less focus on macro forces and more attention being paid to relative valuations within and across asset classes.?

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