Neelkanth Mishra | 2 November 2023
This appeared in the Economic Times on 2 November 2023 (link).
Nineteen months after the Fed started hiking interest rates, and forecasters issued recession warnings, US growth remains robust, with 2023 forecasts getting upgraded. Economic output in the September 2023 quarter rose a remarkable 4.9% year-on-year, much better than expected. This has pushed commentary to the other extreme, with many now expecting a ‘soft landing’ – inflation falling back to target levels without a sharp increase in unemployment and a recession.
Such optimism seems unwarranted. Growth has been boosted by a doubling of the federal fiscal deficit, from $1 trillion in the previous year to $2 trillion in FY ended September 2023 (numbers adjusted for education loan write-offs in the previous year that were reversed this year). A nearly 4% of GDP rise in fiscal deficit is a large stimulus and explains much of the 2% growth upgrade seen this year.
This increase was not due to any direct increase in spending but due to a sharp 19% fall in personal income-tax collection. Lower tax outgo meant higher disposable income, which supported consumption. Without detailed data, it is difficult to conclude why tax collection declined so rapidly. But it appears that changes in tax slabs, the mix of income growth and, partly, a drop in capital gains taxes had a role to play.
Unlike in India, where tax slabs are revised upwards after a gap of several years, in the US, these are adjusted every year for inflation. Given high inflation in the previous year, many taxpayers were probably shifted to a lower tax bracket. Further, wages in lower-income segments have been growing faster than for higher-income ones. Which means that for the same average income growth, the growth in taxes is smaller. With financial assets falling in value, capital gains taxes have declined, too.
The growth impetus would be zero if fiscal deficits remain unchanged. But can deficits expand again? The political divide would make new spending plans difficult. But as US government expenditure is mostly non-discretionary, if taxes fall further, deficits can rise again, pushing out the recession again. However, most of this cushion – ‘automatic stabilisers’ – has been used up.
Personal income-taxes used to be around 8% of GDP in pre-Covid US, but had climbed to 10.5% in the last few years. The Congressional Budget Office (CBO) had been projecting a gradual decline in this ratio over the next decade. But it fell straight to pre-Covid levels in one year. An additional decline of equal magnitude being difficult, a repeat of 2023 appears unlikely.
Even in this scenario, CBO will very likely have to considerably increase future deficit projections, with a debt-to-GDP trajectory substantially above the path currently estimated. This increase in estimated supply of bonds would then keep yields on US government bonds elevated.
In addition to raising interest costs for the government and affecting borrowing rates in the US, the yield on US government bonds also drives up rates for a substantial part of global cross-border capital flows. This is textbook ‘crowding out’. Given that it is the US, the impact is being felt globally. The cross-border impact is intensified by the Fed’s ongoing quantitative tightening (QT).
Shrinking broad money supply and higher nominal economic growth in the US means the gap between the two is negative, the widest at least since 1960. This is a broad brush, but useful proxy for dollar availability outside the US. For some countries with higher foreign ownership of local bonds and flexible exchange rates, this also means higher domestic rates. Note the rate hike in Indonesia recently.
Earlier, I had discussed the policy inversion in the US – while it adopted a tight fiscal, loose monetary stance after the 2008 crisis, it chose a ‘loose fiscal, tight monetary stance’ after Covid for political reasons. Financial markets and economies need to adjust to this shift. Loose monetary conditions in the US in the pre-Covid decade pushed up valuation of assets and supported risk-taking, supporting growth. These are likely to reverse in the coming decade.
Given the incessant rise in US government debt-to-GDP, the only ‘solution’ is the Fed ending QT and start buying government bonds 1again. But it can only justify this if the US goes into recession, or if something breaks in the financial system globally. In either case, monetary conditions would tighten first before they ease after the Fed restarts its bond purchases.
A central bank buying government bonds to keep conditions stable is not without consequence either. Even as CBO remarkably ‘missed’ its deficit projection by a trillion dollars, it has also delayed political debate around debt sustainability. Currently, it does not feature prominently on the agenda of any of the candidates for next year’s presidential election. Adjustments are likely to be acrimonious (spending cuts or tax increases?) and likely to take several years.
It is, therefore, important for Indian policymakers, corporates and investors to remain cautious, focusing on maintaining stability. This may explain RBI’s focus on keeping liquidity tight. Once global conditions ease again, the focus can shift towards accelerating growth.
The muscle memory of financial markets that got used to progressively higher valuation multiples over the past decade needs to change again, with ‘fair value’ multiples likely to be meaningfully lower than prevalent currently.