When will US federal deficits matter?

Adam Berger, CFA, Multi-Asset Strategist
2022-07-31
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Now that the Federal Reserve has moved into tightening mode, it’s worth asking when the US deficits and overall debt could become a source of worry. As long as interest rates stay reasonably low without driving persistently high inflation, I believe deficits and the debt won’t matter too much to the economy or markets. The debt won’t be painful to finance and can continue to grow — within reason. In fact, if economic growth is higher than the interest rate on government borrowing, it’s possible for debt to GDP to shrink even amid sizeable deficits.

The risk of regime change

If rates move up dramatically, however, the cost of financing the debt will go up and pressure the deficit, as higher debt servicing costs will either crowd out other government spending (unlikely) or increase the deficit further (compounding the problem).

For this reason, I think the Fed will be cautious in its tightening approach, with an eye on the “terminal value” of rate hikes. It can steer short rates directly, but shorter-term Treasury bills constitute a little less than 20% of the debt. To influence longer-term rates, it can use policy and language (e.g., anchoring short-term rates for an extended period). Quantitative easing (buying bonds) can have a more potent effect.

The risk of this approach is inflation. If cautious tightening yields high inflation, the Fed may still seek to keep rates low, but buyers (other than the Fed) might decline to buy Treasuries at the rates offered. If the Fed becomes the buyer of last resort to finance Treasury borrowing, we could have a scenario where the Fed is essentially printing money to fund the federal deficit, which would almost certain bode poorly for the US dollar and, eventually, the economy.

In short, this means that in the years ahead, the Fed will have to plot a course between rates that are too low (keeping the debt and deficit in check but risking inflation) and too high (keeping inflation in check but posing the risk that the debt and deficit become unbounded). I’d note that as much as I am concerned about the idea that higher rates could destabilize US fiscal footing, I balance this with worry on the other side that we might head into a Japan-like, permanently deflationary environment where the size of the debt becomes almost irrelevant.

Modest inflation as a pressure relief valve?

I suspect policymakers want to see debt to GDP edge down or at least not continue to rise. (Spending fueled by borrowing is, on some level, pulling forward future spending and therefore a tax on future growth.) The path of least resistance is likely to be “inflating” the US out of its debt burden via somewhat higher inflation — perhaps equal to or even modestly higher than the level of real GDP growth (just as long as it’s not a return to 1970s-style price growth).

This thinking factors into my 10-year expectation of 2% – 3% inflation (vs. 1% – 2% for the past decade or more), but it also makes me worry about a tail outcome that could be worse, as relying on inflation to address a debt burden will require some careful fine-tuning by policymakers.

My base case and risks to my view

We are in a bit of a unique situation where interest rates are low enough that the deficit and debt can be managed (and perhaps even grow) without a big impact on the economy or markets. The cost of government borrowing may not end up below the rate of GDP growth, but even if it’s in the same ballpark, the status quo will likely prevail. This is my base case. Growth is likely to be slow in the decades ahead, which argues for a lower risk-free rate and makes the level of debt and deficits more acceptable.

The big risk is that rates go up significantly. This could happen a few ways. As noted, the Fed could be the driver if it hikes rates too much or lets inflation get out of control. Congress could also be the culprit, if it gets too aggressive on stimulus (e.g., pushing the Modern Monetary Theory idea to a point where rates start to rise or the dollar starts to depreciate). It’s also possible that some kind of external shock could leave the US vulnerable. Finally, the risk could come from overseas, if foreign buyers pull back on their US bond holdings due to inflation, concerns about the long-term fiscal stability of the US, or more benignly, because they can finally earn reasonable returns in their home markets. I don’t think any of these events are on the immediate horizon, but I will be looking out for them if conditions change.

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