Last week the Congressional Budget Office (CBO) updated its deficit estimate, in order to incorporate the recent tax reform and spending agreements.
The fiscal outlook for the US is simply eye watering. The CBO projects the deficit to increase from 3.5% in 2017 to 4.9% for fiscal year 2021. However the forecast is based on overly optimistic growth assumptions. We are of the view that US growth for this year will be healthy and above potential, but 3.3%, as the CBO is forecasting, appears too high. The Bloomberg consensus is 2.8%, while I personally think that 2.5% is more reasonable. Using more realistic growth assumptions, the fiscal deficit for 2019 to 2021 will range between 5 to 5.5%.
Having a large fiscal deficit is not without precedent. Only going back to 2009 the deficit was 10%. But what is certainly unprecedented is this degree of (unnecessary) fiscal stimulus at this point in the economic cycle.
We can debate all day long about the correct level of the NAIRU (the non-accelerating inflation rate of unemployment) – which is 4.6% according to the Fed, versus 4.1% unemployment. But what cannot be put into question is that the economy is close to full employment, that business and consumer confidence indicators are close to all-time highs, that investments are increasing and that the current level of debt is historically elevated as a proportion of GDP. In other words, fiscal loosening is not something that the US requires at this moment in time!
The chart below shows the unemployment rate (rhs, inverted) versus the deficit (lhs) over time. At the current level of unemployment you would expect the US to run a fiscal surplus. In contrast, as the projections show, it will run an even larger deficit.
Chart 1: US fiscal deficit deteriorating
Source: Bloomberg as at 15 April 2018. Projections forecast to December 2020
Aside from the economic rationale (or lack of) of these policies, a large deficit will have implications for the funding requirements in the US. Going back to the CBO estimate, the US Treasury will require an additional $1.7 trillion of funding between 2018 and 2025. To put this number into context, China, the largest holder of US Treasuries, owns $1.3 trillion of them.
It is also important to remember that further financing needs will also be required as the Federal Reserve reduces its balance sheet further. At the current pace, Jeffries estimates that this will add an additional $750bn between FY 2018 and 2021. So overall the US government will have to find a home for an additional $2.5 trillion of Treasuries over the coming years.
There is much debate about the impact that this will have on Treasury yields. Personally I have no concern for the US being able to fund this amount of debt – but I do not think it will be done at current levels. Once the visible hand of the central banks (ECB and BoJ) is lifted, the clearing price will be higher. So far, it has only been the T-Bill market that has been showing signs of indigestion, but eventually longer tenors will have to reward investors with a greater premium (term and inflation) for the lack of frugality of the US government.
One final thought: Mr D. Trump frequently complains about current account deficits with China (among other economies). What he fails to appreciate is that a large proportion of the reserves accumulated have been invested in Treasuries, greatly reducing the cost of the US debt. Reserve diversification (over the last few quarters flows are returning to the euro area) and a greater relevance of the renminbi as a reserve currency might also represent a further challenge for the US government.