The looming fiscal risk

Given current policies, the already large US federal debt will continue to grow and hence, public finances are not sustainable. Although still not a major market theme, concerns seem to be increasing and there was more interest than usual around the budget projections presented on June 18. The primary risk is that markets question whether monetary policy will be allowed to maintain inflation at 2% and hence investors start to demand significantly higher risk premia for markets to clear. That could lead to banks and other financial institutions coming under pressure and large movements in equity and FX markets as well as in bonds. The upcoming election could increase focus on the public finance problem, but it is important to stress that we have no reason to expect imminent financial turmoil. US public finances have been problematic for many years and there are no fixed thresholds for market reactions.

According to the new projections from the Congressional Budget Office (CBO), the federal deficit will equal 7% of GDP this year, decline to 5.5% in 2027 and then increase again to 6.9% in 2034, based on current policies. Debt held by the public will increase from 99% of GDP in 2024 to 122% in 2034. These projections are of course highly uncertain as policies can change and the underlying economy surprise. However, the long-term deterioration is primarily due to increasing “mandatory” spending on things like social security and healthcare that are driven by demographic changes and will be hard to change, as well as by higher interest payments caused by the rising debt. It will likely require major reforms of entitlements (for example higher retirement age) and/or significant tax hikes to stabilise the debt-to-GDP ratio.

However, the ratio can also be stabilised through higher nominal GDP growth. One way to achieve that is through high inflation which could result from financing of the budget deficit by money creation at the Federal Reserve. It is to prevent this from happening that the Fed is politically independent, but if the situation becomes bad enough, the government has the option on leaning on the Fed. Even though there would be a large price to pay for doing that in the form of lost credibility, it is better than outright defaulting on debt, which is therefore very unlikely in our view.

Interest expenses for the government are now equivalent to 2.4% of GDP and will rise to 4.1% over the next decade in the CPO projection. Some, including Treasury Secretary Janet Yellen, argue that this is not the true picture of the burden on public finances from the debt, as there is also a hollowing-out of the debt from inflation – so that the real interest payment is actually negative currently. In the projections, this real interest payment will rise to 2% of GDP in 2034. These projections are based on lower future interest rates than are priced in the market – if we instead use the market rates, the number will approach 3% (see Reading the Markets USD – Unsustainable debt meets uncertain politics, July 2).

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