FINANCIAL NEWS HIGHLIGHTS OF THE WEEK

  • Economic policymakers in Washington squeezed a lot in this week before heading home for the holidays. As expected, the Fed raised rates a quarter point and upgraded their economic growth forecasts
  • Republican members of Congress rushed to wrap up a compromise tax plan to be voted on early next week. While the final details are not yet known, the plan is likely to provide a modest boost to growth over the next few years. But, it has several potentially negative consequences for government finances over the longer-term.
  • Our Quarterly Economic Forecast also features an upgraded economic outlook, in part reflecting better momentum in the second half of the year, and fiscal stimulus.

Taxmas is Coming and the Debt is Getting Fat

 Economic policymakers have been squeezing a lot in before heading home for the holidays. The Fed raised interest rates this week, as Janet Yellen gave her last press conference as Chair. Congressional Republicans were busy wrapping up a compromise tax cut plan. They face a new sense of urgency, since they will face a diminished Senate majority in the New Year once the newly elected Democratic Senator from Alabama takes office. At time of writing, the full details of the tax cut are not yet known, but the House and Senate are expected to vote on it early next week.

Financial News- Chart 1 Given the high likelihood of a fiscal boost, our latest Quarterly Economic Forecast, released this week, incorporates a modest boost to real GDP over the next few years (Chart 1). It’s “Onward and Upward” for the U.S. economy over the next two years, with growth expected to accelerate from 2.3% in 2017 to 2.6% next year.  Even before a tax cut, the U.S. economy appears to be hitting a sweet spot. The unemployment rate is at a 17-year low, businesses are ramping up investment and inflation remains contained. The consumer continues to be a stalwart of the economy. This was confirmed by a strong retail sales report for November. Consumer spending growth is on tracking for a healthy 2.8% annualized pace in the fourth quarter, which marks a rebound from a hurricane-dampened 2.3% pace in Q3.

The Fed also raised its economic growth forecast, but left its expectation for the number of rate hikes over the next year unchanged. The reason for the seeming inconsistency is unclear, but likely it is in part because of continued weakness in inflation would have necessitated a downgrade in the number of hikes, were it not for the offsetting growth upgrade.

All told, this is not a picture of an economy calling out for a fiscal boost. Moreover, deficit-financed tax cuts have several potentially negative consequences for the federal budget, and the economy Financial news- Chart 2 as a whole. First, fiscal stimulus in an economy running full tilt is likely to stoke higher wages and inflation, and could result in a slightly faster pace of rate hikes by the Federal Reserve, ultimately dampening the support to growth. Second, since the personal tax cuts are temporary, a future Congress will need to deal with another fiscal cliff down the road. Third, higher deficits over the next few years (Chart 2)also make it more difficult for the government to respond to a potential economic downturn.

Finally, the plan is estimated to add about one trillion dollars to a debt burden that was already slated to grow due to rising expenditures from an aging population. This means interest costs will eat up more of the budget, leaving less room for other priorities. Larger government debt burdens also crowd out investment in the private sector, dampening productivity growth over the longer term. And, it raises the likelihood of a fiscal crisis – where interest rates on federal debt would rise suddenly and sharply as investors demand additional compensation to hold U.S. debt.

 

Leslie Preston, Senior Economist

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