The imposition of a ceiling on government expenditures in the debt limit agreement reached in Washington adds a fresh challenge to an already burdened US economy grappling with historically high-interest rates and limited access to credit.

The provisional deal, crafted over the weekend by President Joe Biden and House Speaker Kevin McCarthy, and subject to congressional approval in the coming days, manages to avoid the worst-case scenario of a default on payments triggering a financial collapse. However, it does introduce additional risks, albeit marginal, to the prospects of a downturn in the world’s largest economy.

Recent quarters have witnessed federal spending playing a vital role in supporting US growth amidst challenges such as a slump in residential construction. However, the debt limit agreement is likely to at least curtail this impetus. A Bloomberg survey conducted two weeks prior to the agreement revealed that economists had calculated a 65% chance of a recession within the next year.

The spending cap introduced by the agreement will pose a fresh consideration for Federal Reserve policymakers as they revise their growth projections and benchmark interest rates, set to be released on June 14. Futures traders, as of last week, did not anticipate any changes in rates during the mid-June policy meeting, with a final 25 basis-point hike projected for July.

Diane Swonk, the chief economist at KPMG LLP, remarked, “This will make fiscal policy slightly more restrictive at the same time that monetary policy is restrictive and likely to get more so. We have both policies moving in reverse and amplifying each other.”

US stock futures exhibited gains, with S&P 500 index contracts up 0.3% as of 10:40 a.m. in New York. Trading for Treasuries was closed for the Memorial Day holiday, but 10-year Treasury futures were up, leading to a slight decrease in the implied yield to 4.42%.

The spending limits are expected to come into effect with the start of the fiscal year on October 1, although some effects may emerge earlier, such as clawbacks of Covid assistance or the phasing out of student debt forbearance. However, these effects are unlikely to be reflected in GDP accounts.

“Pure Gimmickry”

Tobin Marcus, senior US policy and political strategist at Evercore ISI, advised caution in assessing the extent to which the spending limits are a mere accounting maneuver. He emphasized that it will be crucial to evaluate whether the limits are “pure gimmickry” used to bridge differences.

Even though the deal is expected to maintain spending levels similar to those of 2023, any restraints it imposes will coincide with a potential economic contraction. Economists surveyed by Bloomberg had previously predicted a 0.5% annualized drop in gross domestic product for both the third and fourth quarters.

Michael Feroli, chief US economist at JPMorgan Chase & Co., emphasized the potentially larger impact reduced fiscal spending could have on GDP and employment if the economy enters a downturn. He stated, “Fiscal multipliers tend to be higher in a recession, so if we were to enter a downturn, then the reduced fiscal spending could have a larger impact on GDP and employment.”

JPMorgan’s base case predicts that the US will experience a recession in the second half of 2023.

In the event of an economic slowdown, fiscal policy may complement monetary policy in curbing inflation, which remains above the Fed’s target, as indicated by a recent report.

Jack Ablin, chief investment officer at Cresset Capital Management, remarked, “It’s an important development—it’s been more than a decade since monetary and fiscal policymakers were rowing in the same direction. Perhaps fiscal restraint will be another ingredient to weigh on inflation.”

Despite approximately 5 percentage points of Fed rate hikes since March of last year, which constitute the most aggressive monetary tightening campaign since the early 1980s, the US economy has thus far displayed resilience.

Unemployment currently stands at its lowest level in over half a century, at 3.4%, thanks to robust demand for workers. Furthermore, a recent study conducted by the San Francisco Fed revealed that consumers still have surplus savings from the pandemic.

Fed officials will need to consider various factors, as the agreement will have implications for money markets and liquidity in addition to its impact on the economic outlook.

Since hitting the $31.4 trillion debt limit in January, the Treasury has drawn down its cash balance to meet payment obligations. Once the forthcoming legislation suspends the debt ceiling, the Treasury will increase the issuance of Treasury bills to restore the stockpile to more normal levels.

This influx of newly issued T-bills will effectively reduce liquidity in the financial system, although the exact impact may be challenging to assess. Treasury officials may also arrange the issuance to minimize disruptions.

With the Fed simultaneously reducing liquidity through its monthly bond portfolio run-off of up to $95 billion, economists will closely monitor this dynamic in the weeks and months ahead.

Minimal Impact on Federal Debt in the Long Term

Looking ahead, the scope of fiscal restraint outlined in the agreement is expected to have minimal impact on the trajectory of federal debt in the long run.

Last week, the International Monetary Fund noted that the US would need to reduce its primary budget (excluding debt-interest payments) by approximately 5 percentage points of GDP “to put public debt on a decisively downward path by the end of this decade.”

Keeping spending at 2023 levels falls significantly short of such significant restraint.

Tobin Marcus of Evercore ISI wrote in a note to clients, “The two-year spending caps at the core of the deal are somewhat in the eye of the beholder. Spending levels should stay roughly flat, posing minimal fiscal headwinds to the economy while also only marginally reducing deficits.”

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