North America April 30, 2019 / 07:33 pm UTC

U.S. Fiscal Policy Moves to Center Stage

By Kevin Harris
  • Congressional leaders will attempt to pass a new budget for FY2020 (beginning October 2019), rather than simply rolling over the current budget through a continuing resolution. As part of the new budget, spending caps would be raised by $200 billion (vs $126 billion for FY2019), preventing fiscal policy from becoming contractionary. The White House, however, is signaling opposition to anything but a continuing resolution, with spending caps fully in force. That implies fiscal contraction in 2020.
  • Bottom line: Congress is back in Washington, and turning its attention to the budget, making this an apt time to review the fiscal outlook. Budget law, as it stands, requires fiscal contraction in 2020, but that can be changed through legislation. There is also discussion underway of an infrastructure spending bill, with Democrats looking for taxes to pay the cost while Republicans look for cuts to non-military discretionary spending or to increased debt to finance new infrastructure. 
  • Market implications: There are substantial growth and debt issuance implications to both the budget negotiation and the possibility of an infrastructure spending plan. The fiscal shock that would result from relying on a continuing budget resolution, without waiving spending caps, would be too small to induce recession on its own, but would certainly slow growth and increase recession risks. The Fed would be more likely to cut rates if fiscal policy were to turn contractionary. Treasury supply would slow, which along with slower growth would put downward pressure on yields. Stocks would be under pressure from a diminished outlook for earnings.

Figure 1: Federal Debt and Deficit as a Share of GDP

Source: Congressional Budget Office, Treasury Department, Bureau of Economic Analysis, Continuum Economics

The Fiscal Outlook, as It Stands

With the near-simultaneous passage of tax cuts and increased spending in late 2017 and early 2018, concern that fiscal contraction and monetary overshoot could lead to trouble in 2020 began to grow. With the Fed now on hold, one concern has diminished, but the fiscal contraction is under active debate in Washington. 

As things now stand, a continuing budget resolution to fund government operations beyond this September, with no increase in spending caps, would result in a fiscal contraction of roughly 0.6% of GDP in FY2020. At the same time, the incremental Keynesian growth effects of the 2018 tax cut falls to zero in 2020. The swing from a small contribution in 2019 to flat in 2020 would cut another 0.2% to 0.3% from 2020 growth. 

If there were strong microeconomic effects from the tax cut, we might expect an improved growth trend beyond the incremental Keynesian effect. However, since the tax cut does not seem to have lifted the pace of investment in new productive assets, we do not expect much lift to trend growth.

The Fiscal Outlook, as It Is Shaping Up in the Halls of Congress

House Speaker Nancy Pelosi and Senate Majority Leader Mitch McConnell have agreed to negotiate a two-year spending bill that would raise discretionary spending caps by roughly $200 billion (roughly 1% of GDP). That 0.4% difference, between 0.6% and 1.0%, is the incremental fiscal lift to be expected in 2020 if Pelosi and McConnell have their way. That does nothing to amend the 0.2% to 0.3% drag on growth as the incremental Keynesian benefit of the tax cut goes to zero in 2020, so in reality, the net fiscal boost in 2020 would be 0.1% to 0.2% if the Pelosi/McConnell plan passes. Given the uncertainties of federal budgeting, 0.1% to 0.2% of GDP is essentially zero.

Not So Fast, Says Trump

President Donald Trump, meanwhile, has said he wants spending caps to remain in place in order to bring down discretionary spending. Given the narrow party split in the Senate, there is a good chance Trump can veto any budget bill he chooses. If he insists on leaving budget caps in place, they will be left in place, and the net fiscal drag from the aging of the tax boost and the imposition of spending caps could be 0.7% to 0.8% of GDP. We see a strong possibility Trump will rethink imposing a fiscal contraction in an election year, but that is his position for now.

One thing we suspect might be in the back of Trump’s mind is to demand funding for a wall on the border with Mexico in return for agreeing to the budget expansion Pelosi and McConnell seek. 

And Maybe Infrastructure

Pelosi and Senate Minority Leader Chuck Schumer met with Trump today to discuss an infrastructure package. Reports from the meeting indicate they agreed on a $2 trillion price tag and will meet again to discuss how to pay for the spending. Schumer said that the president has agreed to come up with a funding proposal. Political leaders in both parties extoll the benefits of such a package, but there is sure to be lots of disagreement over what gets built and how it gets paid for. 

Pelosi and Schumer have a wish list for any big infrastructure spending effort, saying they want spending on broadband, water, (alternative) energy, schools and housing, and that a tax increase for corporations and the wealthy is the right way to pay for the plan. The fact that there has been so little partisan bickering over infrastructure this year is a sign of how much all sides want a big increase in infrastructure spending. However, the idea of taxes to pay for that spending will not go over well with Congressional Republicans or with Trump. 

Figure 2: Infrastructure Spending Losing Ground

Source: Census Bureau, Bureau of Economic Analysis, Continuum Economics

Of course, a border wall is an infrastructure project. The White House may want to tie fiscal expansion and infrastructure spending together, with funding for “the wall” required to clinch both deals.

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