The fiscal tailwinds are still blowing

Summary

Government hiring and output have accelerated this year even as indicators of private sector economic activity have shown some signs of slowing. Nearly one-quarter of the 2.6 million jobs added to the U.S. economy year-to-date have been in government, with payrolls up 2.9% over the past year versus 1.6% in the private sector. The government component of GDP (you may recall the formula GDP = C + I + G + NX from an economics class back in the day; G is government output) was up 4.7% year-over-year in Q3, near the strongest growth rates of the past 30 years.

Some of this pick-up can be attributed to a delayed rebound from the pandemic. October 2023 marked the first month in which government employment was above its February 2020 level, a threshold private nonfarm employment eclipsed in April 2022.

Flush state and local (S&L) government coffers also explain some of the strength. The vast majority (nearly 90%) of public sector workers are employed by S&L governments, and the fiscal situation for many of these entities has been relatively healthy over the past couple years. Robust tax receipt growth, significant federal aid and generally strong balance sheets have bolstered S&L governments' fiscal flexibility.

At the federal level, new policy initiatives have helped to boost output and hiring growth. More spending has started to come online for veterans, national defense, infrastructure and other areas, contributing to an acceleration in government hiring and production.

How long can this boom continue? In the near term, we believe the solid growth in government hiring and output will persist. S&L governments are still playing catch-up on hiring from the pandemic hit, and this momentum should continue a little while longer. Although S&L tax revenues are not growing as fast as they once were, they are also not collapsing. Federal aid from the pandemic is dwindling much like excess savings are for households, but the evidence suggests that these funds are not yet fully spent. Infrastructure funding from the federal government is also still ramping up, and the impact on economic growth likely will not peak for another year or two.

However, we believe the tide is starting to turn. At the federal level, the willingness to expand the deficit seems to be waning. There have been no new major fiscal expansions in 2023, a sharp contrast to the numerous bills passed from 2020-2022. As we look to next year, it strikes us as unlikely that Congress will pass any new major fiscal initiatives in an election year. At the S&L level, tax receipt growth is unlikely to return to double-digit territory anytime soon, and eventually leftover federal aid from the pandemic will be exhausted.

More broadly, fiscal austerity as a political issue may be slowly coming back into vogue amid a period of high inflation, elevated federal debt levels and rising interest costs.

On balance, the fiscal tailwinds are still blowing, but they are not as strong as they once were, and we believe they will keep fading as we get closer to 2025 and beyond. Government hiring and output can serve as one of the pillars propping up economic growth and the labor market in the near term. That said, this boost will not last forever, and the headwinds from restrictive monetary policy are still exerting a drag on the U.S. economy. In order to achieve a “soft landing,” sooner or later a Federal Reserve pivot will be needed to keep this expansion going.

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