By Partha Chakraborty–
(Partha Chakraborty, Ph.D., CFA, is an economist, a statistician, and a financial analyst by training. Currently, he is an entrepreneur in water technologies, blockchain and wealth management in the US and in India. Dr. Chakraborty lives in Southern California with his wife and teenage son. All opinions are of the author alone.)
Last Wednesday, Fed Chair Jerome Powell almost sounded relieved. Fed’s confidence in the base of soft landing had grown, he said to reporters after the Fed meeting, “We’ve seen so far the beginnings of disinflation without any real costs in the labor market.” “That’s a really good thing,” he added for a punchline.
Chair Powell has reasons to be elated. Starting from zero in March 2022, the Fed raised rates to a 5.25-5.5% range in its latest meeting, the highest in 22 years, the Fed staff, which earlier this year projected a recession, no longer does.
Inflation excluding food and energy came at 3.8% annualized for the quarter, lower than economists expected, as headline inflation number came back to 3%, both lowest in over two years, but both are far above Fed’s comfort zone.
The second-quarter report on gross domestic product also helped the case for a soft landing — recorded 2.4% growth rate was faster than the economy’s long-run trend.
America is running a budget deficit worth over 5% of GDP— unheard of outside recessions and wars. That, however, is putting money in people’s pockets.
Spending on highways, ports, power plants and more, enabled by an infrastructure law passed in 2021, is worth about 0.25% of GDP a year. Subsidies for electric vehicles, renewable energy and semiconductors appear to have catalyzed a surge in private-sector investment: spending on manufacturing facilities is up 70% this year in real terms compared with pre-pandemic levels, hitting a record high.
Another countervailing force is households, whose spending accounts for about two-thirds of GDP. They entered the era of high inflation and rising rates well prepared. During the pandemic they had accumulated “excess savings” worth about $2 trillion.
Many people have drawn down these savings as the cost of living has risen. Nevertheless, researchers with San Francisco Fed estimate that there is still a residual $500 billion in extra savings, enough to last for most of this year. To top it, most Americans now have rising incomes in real terms.
Not everybody was as impressed, though with the resilient economy, some even found it discomfiting. If wages continue to grow at about 5% annually, they, too, will put a floor under prices in the service sector.
Expectations of inflation, although declining, are still too high — both 1 year and 5-year ahead inflation expectations top 3%. A feedback loop between a strong economy and sticky inflation poses a stiff challenge for the Fed, leaving it with little choice but to raise rates, causing the economy to step into a possible recession.
“We don’t know what the next shoe to drop is,” said Ms. Subadra Rajappa, head of U.S. rates strategy at Société Générale, a French Investment Bank, observing that credit has been getting harder to come by applying brakes on the economy. “It looks like we’re headed toward a soft landing, but we don’t know the unknowns,” she added.
Looking at the future, Olivier Blanchard, a former chief economist of the International Monetary Fund, and Ben Bernanke, a former chairman of the Fed, estimated that, at the current level of tightness in the labor market, the unemployment rate would need to rise above 4.3% for some time to bring inflation down to the Fed’s target.
That would imply that roughly one million people would have to lose their jobs — no small dislocation, especially considering that US economy as 1.5 times as many open jobs as unemployed.
“The prevailing consensus right before things went downhill in 2007, 2000 and 1990 was for a soft landing,” said Gennadiy Goldberg, a strategist at TD Securities. “Markets have trouble seeing exactly where the cracks are.”
One such crack appeared on Aug 1. Fitch Ratings, a London based global rating agency, downgraded US long term ratings to ‘AA+’ from ‘AAA,’ while notching up Ratings Watch from “Negative” to “Stable.”
“The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions,” Fitch wrote in an accompanying note.
On “Erosion of Governance,” you get the usual suspects – political standoffs leading to last-minute hail-Mary acts on both sides being the primary driver. Further, Fitch faulted lack of a ‘medium term fiscal framework, unlike most peers.”
No question, all of that adds to the ballooning of current debt burden as well as future entitlement commitment.
On “Expected Fiscal Deterioration” page of the ledger, Fitch puts spotlight on a sorry status-quo. The deficit in the first nine months of this fiscal year hit $1.4 trillion, up 169% from the same period the year before. General Government Deficits rose from 3.7% in 2022 to 6.3% projected in 2023, 6.6% in 2024 and 6.9% in 2025, state and local governments add about 1.2% on top. Nominal Debt to GDP reached a Pandemic high of 122.3% in 2020, up from pre-Pandemic of 79.4%, will reach 112.9% this year, and 115% by 2033.
Combined with state and local borrowing, this metric is more than two and a half times the average for the AAA rated. Not surprisingly interest costs are skyrocketing, especially in a rising rate environment.
The US spent $131 billion more on interest payments so far this year, up 25% from last year, Congressional Budget Office (CBO) predicts interest costs will double to 3.6% of GDP by 2033.
Not that we seem to be too bothered. Fitch expects near-term impact of the Act is estimated at $70 billion (0.3% of GDP) in 2024 and $112 billion (0.4% of GDP) in 2025.
Fitch does not expect any further substantive fiscal consolidation measures ahead of the November 2024 elections. CBO expects spending on Social Security to grow from 5.1% of GDP in 2023 to 6.0% in 2033. Spending on Medicare, Medicaid and other mandatory health programs will rise from 5.8% of GDP to 6.6% over the same period, per CBO.
Social Security’s trust fund will run out in 2033, while Fitch estimates Medicare’s hospital-insurance trust fund will be depleted by 2035. Interest to Revenue ratio will reach 10% by 2025, Fitch calculates, compared with median 1% for AAA economies.
Countervailing all these, US has the “exorbitant privilege” of being the world’s reserve currency, its biggest economy, a very diverse and vibrant population, strong military and democratic mechanism that works despite everything. All in, Fitch only reduced ratings by one tiniest notch.
Not that A lower credit rating is likely to change a fundamental political calculus. “The U.S. is in a really strong position, and that’s an appropriate judgment on the part of investors. I worry that judgment is breeding really problematic complacency on the part of elected officials,” said Michael Strain, the director of economic policy studies at the American Enterprise Institute, a conservative think tank.
Echoing from the other side, Ben Harris, a former top Economist at the US Treasury, commented “I don’t think it should shape how people feel about debts and deficits. We’ve known we’ve had a long-term imbalance for decades and this doesn’t change anything.”
No wonder Goldman Sachs, a US investment bank, put its estimate of climate-related expense under Inflation Reduction Act at $1.2 trillion, triple the estimate of CBO, and cost for EV subsidies at $393 billion, as opposed to $14 billion as in the bill. QED.
Where does this lead to? I find it hard to refute logic of Fitch, even if timing of their call was sudden. As a former securities analyst, I will hazard that Fitch may have wanted to take the lead on downgrading US this cycle. Even if they are early, drivers of their call face a one-way street that only leads to worsening of fundamentals, further validating Fitch’s call.
I predict other agencies make some noise about a possible downgrade, or ratings watch, soon. If a threshold number of rating agencies band this way, institutional holders of US government debt will be mandated to rebalance their portfolios, pushing yield up. This translates to higher cost of all kinds of debt, public and private, thereby raising a patch of ominous cloud where there was none. Fed could lower rates to counter, but would rather not unless drivers of inflationary pressure are fully abated.
We did see this coming, I will argue. In these pages we lampooned supply chain debacles that started inflationary pressures, railed against rising deficit and government profligacy predicting they could force a fall from grace for the US dollar, advocated in favor of using debt-ceiling drama as a lever to bring wayward spending down; last week we discussed how the high-minded — and well intentioned — efforts at crafting a US “industrial policy” might not mean that much. Every single driver Fitch mentioned was flagged as a concern, if not a three-alarm-bell issue.
I will stick to my call of a US recession in 2024. If ratings actions expedite the misfortune, I will be sad, but right. I am happy to be in a no-win situation.