The Big Idea

A dark fiscal outlook

| May 31, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

With elections looming in November, the federal budget outlook is likely to become a popular topic in coming months. The conversation is unlikely to be a happy one. Annual federal budget deficits are on track to run at close to 7% of GDP, a clearly unsustainable flow of red ink. It seems most Street economists are underestimating the current year and future deficits.  Moreover, the elections represent a mostly one-way risk, as the federal government next year will probably either remain in gridlock, maintaining the fiscal status quo, or, if one party gains full control budget deficits are likely to swell further.

Gauging FY2024 budget

The current fiscal year is nearing the end of its eighth month. The results through April offer a mildly encouraging picture. The year-to-date federal budget deficit totaled $855 billion, a $69 billion improvement from the red ink over the corresponding year-ago period.

April 15 tax receipts were robust. Nonwithheld individual income tax payments this year topped last year’s tally by almost $60 billion, or about 15%, while corporate income tax payments exceeded year-ago levels by about $10 billion.  In all, federal revenues are running close to 10% ahead of corresponding year-ago levels through April. This windfall has been mostly offset by a sizable increase in federal outlays, much of which reflects higher interest costs.

The annual federal deficit in FY2023 was $1.694 trillion.  Given the modest improvement through the first seven months of the current fiscal year, the consensus projection of a modest narrowing in the deficit for FY2024 seems reasonable at first glance. In the last refunding cycle, the Treasury’s survey of primary dealers, conducted about a month ago, found a median estimate of $1.635 trillion.

However, appearances may be deceiving. The trick that most forecasters appear to be missing is that in August 2023, Treasury made a $319 billion accounting adjustment that lowered the deficit to account for the Supreme Court’s reversal of the Biden Administration’s student loan initiative.  Adjusting for this one-off, the underlying budget deficit in FY2023 was actually just over $2 trillion.

Consequently, if the FY2024 is tracking to run about $100 billion smaller than last year, then the estimate should be over $1.9 trillion, which happens to be my current forecast, not $1.635 trillion.

Looking ahead

The trajectory of federal budget deficits over the next few years will of course depend heavily on the performance of the economy.  I am assuming a fairly benign economic outlook—I have slower GDP growth in 2025 but not a recession—which I project would result in federal deficits widening modestly over the next few years.  My latest estimates for FY2025 and FY2026 are $2.0 trillion and $2.1 trillion, respectively, a deterioration of around $100 billion per year.  These year-to-year changes are not radically different from the Street consensus, but the higher base deficit in FY2024 carries forward. The median estimate of primary dealers in Treasury’s recent survey was about $1.8 trillion for both FY2025 and FY2026.

While my projected trajectory for the fiscal outlook beyond this year is similar to the consensus, my forecasts call for deficits over the next three years that are cumulatively well over $800 billion larger than the consensus view.  Even in the context of the mammoth Treasury market, this represents a substantial difference.

Policy risks

With an election looming in November, the fiscal trajectory is subject to significant change next year.  In my view, this represents a mostly one-way risk – toward higher deficits. The status quo reflects gridlock, as a divided Congress has struggled over the past 17 months even to extend the debt ceiling and pass a budget.

Most political experts are projecting that Congress will remain divided in 2025 and 2026, though the consensus has the Senate flipping to Republican control, while the House majority swings to Democrats. In that case, the winner of the presidential race is likely to struggle to pass any major new initiatives.  My forecasts implicitly assume that Congress will remain mostly gridlocked.

The alternative would be that one party sweeps the races in November, as Republicans did in 2016 and Democrats did in 2020.  In each case, unified control of Congress and the White House led to deficit-expanding policies.  The Trump Administration and Congress enacted a substantial tax cut package in 2017, while the Biden Administration and Congress passed a series of major spending bills in 2021 and 2022—Covid relief, an infrastructure bill, the CHIPS Act, and the Inflation Reduction Act—that continue to generate large federal outlays.

My base case consequently could represent close to a best case for the fiscal outlook.  Any deviation from the status quo seems likely, based on recent history as well as the major presidential candidates’ proposals and rhetoric, to enlarge rather than shrink future budget deficits.

One specific issue that the next Administration and Congress will have to deal with is the pending expiration of the 2017 tax cuts next year.  Republicans generally favor extending most or all of the cuts, with the main disagreement within the caucus over whether an attempt should be made to pay for at least a portion of the cost. Most Democrats, including the Biden Administration, are arguing for extending most of the cuts but allowing breaks for corporations and upper-income households to expire. If Congress is split next year, the debate over what to do with the 2017 tax cuts could prove every bit as rancorous and prolonged as the 2023 debt ceiling discussions and recent budget talks.

Market discipline

With no one in Washington pushing for fiscal discipline and voters not clamoring for austerity, it is hard to see how the deteriorating budget outlook will get fixed.  In my view, the only realistic scenario in which fiscal restraint occurs in the foreseeable future is if the financial markets demand it. If investors begin to require a substantial premium for holding long-term Treasury securities due to fiscal or supply worries, the ensuing jump in interest rates could get policymakers’ attention.  We saw a taste of this last summer and into the fall, when the long end of the Treasury market sold off, in part due to budget concerns, though the concerns promptly melted and have yet to re-emerge this year.

This dynamic happens often around the world—ask Liz Truss in the UK about how quickly the financial markets can turn on a government’s fiscal policy—but it has not been seen in the modern history of the US, so I suspect most domestic investors are not paying much attention to the risk.  If my recent client visits in the UK and Europe are an accurate indicator, then foreign investors are extremely tuned in to the US fiscal situation and may be beginning to wonder whether the time has come to demand action.

While such a scenario could conceivably provide the ultimate resolution of the unsustainable fiscal outlook, it would certainly not represent a happy outcome.  The combination of higher benchmark interest rates coupled with future fiscal restraint would add up to a double whammy to the prospects for U.S. economic growth.  In any case, buckle up.  It looks like there could be turbulence ahead.

Stephen Stanley
1 (203) 428-2556

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