Financial News for the Week of May 26th, 2023

Thankfully, negotiators appeared close to a deal to raise the debt ceiling as of Friday morning in financial news. It looks like the two-year deal would cap discretionary spending and raise the debt ceiling through the 2024 election, avoiding the worst-case scenarios. However, ratings agency Fitch had cited the “failure of the U.S. authorities to meaningfully tackle medium-term fiscal challenges” as a reason for putting the U.S. on a negative watch, and this deal does not change that.

Congress has taken the Shakespearean proverb “discretion is the better part of valor” literally. The Bard’s original intention was a criticism of a lack of honour and courage in focusing on discretion. The debt ceiling deal only tinkers around the edges of the larger issue of a structural deficit on the order of 6% of GDP.

Discretionary spending accounts for only 27% of total federal government outlays, and the federal deficit is estimated to be $1.5 trillion in 2023. As shown in Chart 1, Congress would need to cut discretionary spending nearly to zero to balance the books if they only address discretionary spending. To seriously address the deficit, it needs to take the more courageous steps and look at mandatory spending – namely entitlements like social security and Medicare. Or, it needs to find a way to grow revenues at the same pace as population aging. Alas, courage seems in short supply in Congress these days.

Speaking of discretion in spending, real consumer spending was up a healthy 0.5% month-on-month in April in financial news. Spending was driven by robust  gains in outlays on both goods and services. Monthly spending data has been very choppy over the past six months but comparing it to real income less transfer payments (which is a key recession indicator used by the NBER), you see that the upward trend in spending is outpacing real income growth (Chart 2).

Thanks to a strong labor market, real income gains have held up. Added to the cushion of excess savings built up during the pandemic, the consumer has been able to keep spending in the face of very high inflation, in turn contributing to demand-driven inflation pressures. Chart 2 suggests that spending is set to slow – even if the labor market doesn’t cool. About 60% of the excess savings cushion has been spent, and spending cannot outgrow income indefinitely before consumers will need to tighten their belts.

We expect that belt tightening to be in greater evidence as the year goes on. After consumer spending grew by 3.8% annualized in Q1, it is tracking a more modest 2% in Q2. We expect it to fall below 1% in the second half of the year, which will help to dampen inflationary pressures. Until then, the Fed is on the horns of a dilemma.
Its preferred inflation gauge, the core PCE deflator, remained around where it has been all year at 4.7% year/year in April. Markets are judging this could mean the Fed should push a bit harder on rates, with market odds tilting slightly in favor of another hike in June. We believe that the Fed will need to hold its courage and pause and assess the impact of the significant monetary policy tightening that has not yet had its full impact on economic growth.

 

Leslie Preston, Managing Director & Senior Economist | 416-944-5307