Policy Watch A perfect storm*
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By Carlos B. Cavalcanti @ ResearchGate October 30 2018 The minutes of the Federal Open Market Committee (FOMC) meeting on September 25-26, issued on October 18th, highlighted concerns about remaining strong economic growth and endorsed plans to continue gradually raising short term interest rates, with a view to reduce the risk of the economy overheating. Real GDP growth in the third quarter of 2018 was estimated to have reached 3.5%, yielding a 3.3% growth rate for the year (Figure 1). As a result, the labor market continues tighteneding and the current account deficit widdendening (Figures 2 and 3). Figure 1: US Quaterly GDP, 2017-2018 ($ Billion) 20,755.0
20,555.0
20,355.0
20,155.0
19,955.0
19,755.0
19,555.0
Q3
Q4
Q1
Q2
Q3
2017
2017
2018
2018
2018
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Figure 2: Total Non-Farm Payroll Employment, 20172018 (Thousand) 150,055 149,555 149,055 148,555 148,055 147,555 147,055 146,555 146,055 145,555
Figure 3: Balance of Goods and Services, 2018 ($ Million) -$40,000.00 2018-05-01
2018-06-01
2018-07-01
2018-08-01
-$42,000.00 -$44,000.00 -$46,000.00 -$48,000.00 -$50,000.00 -$52,000.00 -$54,000.00
The next day (10/19), the U.S. Treasury Department released its monthly report showing that the U.S. Federal government had run its largest largest deficit in 6 years (Figure 4). It was an unusual development for a fastgrowing economy and a sign that the tax cuts signed into law in late 2017 had led to a decline in government revenues. The deficit is expected to reach $1 trillion in the 2019 fiscal year. Deficits usually shrink during economic expansions because strong growth leads to increased tax revenue while spending on safety-net programs tends to tail off. However, in fiscal year 2018, interest payments on the federal public debt and military spending rose rapidly, while revenue failed to keep pace, as the tax cuts for both individuals and corporations did not increase as expected.
Figure 4: Federal Government Operational Balance, 2017-2018 ($ Million) 500 -1500
-3500 -5500 -7500
-9500
The expectation that a growing economy would generate additional government revenues failed to materialize. Instead, the economy is growing in large measure because of falling revenue. In the three months before the tax cut was implemented on January 1st, 2018, federal revenues rose 4% from a year earlier and real GDP rose 2.5%. In the nine months after, revenues fell 1% and growth accelerated to 2.9%. The tax cut pushed the budget deficit up to 3.9% of GDP in fiscal year ended on September 30th, 2018, up from 3.4% in fiscal 2017. Adjusting for a shift in social security payments the deficit actually jumped to 4.1% of GDP from 3.2%. The tax overhaul appears to have been a conventional demand-side stimulus, not the supply-side lift claimed by the Trump administration that the economy would receive from the tax overhaul, which would had led to a shrinking of the budget deficit. As a result, when demand stimulus fades, so will the growth stimulus, leaving behind only an elevated Federal public debt (Figure 5). Figure 5: Total Public Debt as a % of GDP 20017-2018 (%) 105.5 105.0 104.5 104.0 103.5 103.0
The consequence of the increase in the fiscal deficit was a widenning balance of payments current account deficit. This deficit is projected to rise to $650 billion by 2019, up 50% from the $430 billion recorded in 2017 -the first year of the Trump administration. The current account defict reflects the difference between what the U.S. consumes and produces, with the missing goods and services being supplied by foreigners. While this deficit had existed for many years, it has recently increased, despite the import tariffs introduced in 2017 and further increased 2018. While tariffs protect the output of industries that had recently been replaced by imports, this protection draws factors of production (capital and labor) that had been employed by other industries that were meeting the demand from domestic and foreign markets. A higher current account deficit implies that the U.S. is drawing saving by other countries to bridge its financial gap, and to be able to attract more it will need to pay a higher intest rate. Capital is already being drawn from emerging countries and transferred to the U.S.. Although this flow puts pressure on emerging market currencies, the recent uptick in demand from the U.S. also led the stock market index to fell the competition for funds (Figure 6). The danger of a global debt crisis was recently highlighted during the IMF-World Bank annual meeting in Indonesia in early October, and can be mitigated primarily by shrinkiing the U.S.’ current account deficit. The experience of many developing countries shows the risk of depending on fickel foreign capital, leading to ‘sudden’ stops in these flows, causing the engines of growth to also come to a halt. While the privilege of issuing the U.S. dollar precudes a similar fate for the U.S., another financial crisis can only be avoided by shrinking the fiscal deficit or by raising the interest rate Federal government pays on its debt -- although that will also lead to a slowdown in growth. Figure 6: Dow-Jones Industrial Average, September-October 2018 27300.00 26800.00 26300.00 25800.00 25300.00 24800.00 24300.00
It is emblematic that overseas investors, traders and central banks were reported to be buying less U.S. Treasury securities over the first eight month of this year, compared to the same period last year (the data is released with a lag). The question is whether this is a possible turning point for this $15 trillion market at the center of global finance and economics. Foreigners increased their holdings of U.S. Treasury securities by $78 billion in during this period, amassing just over half of what they bought during the same period last year. This drop in foreign interest in U.S. Treasury securities comes at a moment when the U.S. government is increasing the size of its bond auctions to fill a growing budget gap. Conclusion. A perfect storm is brewing, triggered by a large fiscal deficit that has, predictably, spilled into the current account. Strong economic growth supports the Fed’s strategy to continue raising short term interest rates. Although another interest rate increase will not be anounced at the next FOMC meeting (November 7-8), this increase is likely happen at the December 18-19 meeting. While the stated objective will be to cool-off the economy, the underlying reason is the widdening U.S. budget deficit that is placing additional demands on domestic and foreign savings. This is important because interest payments on the Federal public debt were already amongst the fastest growing expenditure items last fiscal year (that ended on September 30), increasing by $62 billion (or 20%) over what was reported for 2017. This increase was due both to higher interest rates and a larger debt. A vicious cycle appears to be emerging, whereby U.S. interest rates rise to attract needed domestic and foreign savings, but in the process will also slow down domestic growth, making the budget deficit problem more intractable.
