Economics Group. Special Commentary. May 21, 2018

Transcription

1 Economics Group Special Commentary John E. Silvia, Chief Economist (704) Michael A. Brown, Economist (704) Michael Pugliese, Economist (212) Abigail Kinnaman, Economic Analyst (704) Budget and Economic Outlook Executive Summary On April 9, the Congressional Budget Office (CBO) released its annual Budget and Economic Outlook that steps through its projections for the economy, the federal budget and the deficit outlook for the next 10 years. This year, while many of the key themes CBO has discussed before remained the same, the scale of the budget challenges facing the U.S. government over the next decade have grown immensely in the wake of the tax package and additional federal spending enacted over the past year. In this report, we highlight some of the key economic assumptions of the CBO and provide an overview of its budget baseline. Along the way, we compare CBO s outlook with our own forecasts and discuss the risks to these estimates. We conclude with a comparison of our outlook for the U.S. budget deficit versus CBO s estimates. We find that relative to CBO, our economic growth assumptions for calendar year 2018 and 2019 are lower. This in turn leads us to conclude that federal revenue growth is likely to come in slower than CBO s baseline measures if our forecast plays out as expected. We are also more pessimistic that federal outlays will be as contained as CBO suggests, leading us to conclude that higher spending will result as scheduled budget cuts fail to transpire. In putting the pieces of these assumptions together, we find that the federal budget deficit is likely to rise to $775 billion in FY 2018 and $1.1 trillion in FY While we do not yet forecast the federal deficit beyond FY 2019, we see upside risk to CBO s estimates based on our view that Congress will likely backfill many scheduled budget cuts and maintain many tax breaks. In short, federal budget deficits are set to swell in the coming years and approach all-time highs. We remain somewhat concerned at the pace of increases in the federal deficit in the coming years and the potential impact on economic conditions and Treasury markets. Figure 1 Figure U.S. Budget Gap CBO Baseline Scenario Projections, Percent of GDP Forecast 2 2 Real GDP Growth Estimates Comparison to CBO Assumptions, Year-over-Year Percent Change CBO Forecast WF Economics Forecast Blue Chip Consensus In this report, we highlight some of the key economic assumptions of the CBO and provide an overview of its budget baseline. 2 Avg. Outlays % 18% 1 Outlays: 23. Avg. Revenues Revenues: Source: Congressional Budget Office, Blue Chip and Wells Fargo Securities

2 We agree with CBO that a fiscal policy expansion with the output gap essentially closed will result in higher inflation in Differences in Underlying Economic Assumptions One of the most important aspects of the baseline fiscal outlook in CBO s report is the underlying economic assumptions including GDP growth, potential GDP growth, the inflation outlook and the future path of interest rates. Turning to the near-term economic outlook, CBO estimates that the economy will expand at a 3.0 percent pace in 2018 and 2.9 percent in 2019 on a year-over-year basis. For comparison, our February forecast called for 2.9 percent GDP growth for this year and 2.8 percent for 2019 (Figure 2 and Appendix). 1 With respect to inflation, CBO estimates that the year-over-year growth in the Consumer Price Index will end up at 2.2 percent for this year and 2.2 percent next year. Our forecast for inflation differs from CBO for both years related to our expectation around timing of inflationary pressures. We see the CPI growing 2.4 percent this year and 1.9 percent next year (Figure 3). The differences in our headline PCE Deflator estimates are more subtle, with CBO projecting 1.8 percent for this year and 1.9 percent for next year compared to our estimates of 2.1 and 1.9 percent, respectively. While there are slight timing differences in our inflation outlook, the theme is the same we agree with CBO that a fiscal policy expansion with the output gap essentially closed will result in higher inflation in Figure 3 Figure Consumer Price Index Estimates Comparison to CBO Assumptions, Year-over-Year Percent Change CBO Forecast WF Economics Forecast Blue Chip Consensus Estimated Average 10-Year Treasury Yield Comparison to CBO Assumptions, Percent CBO Forecast WF Forecast Blue Chip Consensus CBO expects the FOMC to hike rates three more times this year, with the effective fed funds rate ending the year at 2.4 percent. Source: Congressional Budget Office, Blue Chip and Wells Fargo Securities Combining its growth and inflation assumptions, CBO forecasts that the FOMC will continue to hike rates and, as a result, nominal rates across the yield curve are set to rise more dramatically through the end of CBO expects the FOMC to hike rates three more times this year, with the effective fed funds rate ending the year at 2.4 percent. CBO sees the Fed continuing to hike four more times in While our outlook for fed funds rate hikes is the same for this year, we currently are only forecasting two hikes in 2019 in anticipation of the FOMC slowing the pace of hikes as the effective fed funds rate approaches our estimate of the neutral rate of 3.0 percent. CBO in turn expects the 10-year U.S. Treasury yield to average 3.0 percent this year and 3.7 percent next year compared to our estimates of 2.9 and 3.3 percent, respectively (Figure 4). As we discuss later, the higher interest rate environment assumed by the CBO is likely to translate into significantly increased borrowing costs for the federal government. Beyond the near-term outlook, CBO provides projections for growth over the next 10 years. Its methodology involves estimating a potential rate of GDP growth and then determining how far current conditions deviate from this potential estimate. In the long run, CBO expects growth to return to its estimated potential rate. CBO estimates potential GDP growth to average 1.9 percent over the next 10 years. A comparison of our long-term growth forecast, the Blue Chip Consensus forecast and that of the CBO can be found in Figure 2 above. As can be seen, we are slightly more optimistic about long-run GDP relative to CBO s projections. That said, our long-term forecast was 1 We are using our February 7, 2018 forecast for all forecast comparisons to reflect the cutoff date that the CBO used for its economic assumptions. 2 Congressional Budget Office. (April 2018). The Budget and Economic Outlook: 2018 to Pg

3 developed last December and did not include the crowding out of private investment anticipated from higher federal budget deficits that transpire from higher outlays and slower revenue growth. Mandatory Outlays to Drive Federal Spending Higher through 2028 On the outlay side of the equation, many of CBO s existing assumptions for steadily increasing federal spending over the next 10 years, coupled with additional spending increases from the Bipartisan Budget Act of 2018, lead CBO to project that federal debt held by the public will reach nearly 100 percent of GDP by How did we get here? For starters, several of the themes CBO has previously seen driving federal spending higher remain intact, particularly for programs that fall under the mandatory spending category. Rising interest rates also lead CBO to project higher net interest costs over the coming decade, adding further to the federal debt. Mandatory spending, which includes outlays for the major healthcare programs and Social Security, is expected to continue to rise as a share of total spending over the next 10 years. CBO looks for mandatory spending to surpass 64 percent of total spending by 2028 (Figure 5), with the continued aging of the population and rising healthcare costs as key drivers of this increase. Between 2018 and 2028, the share of the population aged 65 or older is expected to grow roughly 34 percent, while the share aged 20 to 64 is expected to increase a smaller 20 percent. 3 A larger proportion of the population eligible for Social Security benefits will weigh on already-limited program funding. Similarly, the federal Medicare and Medicaid programs also face not only an increasing number of program enrollees, but also rising cost pressures. Until recently, healthcare costs have risen more slowly than in CBO s projections; however, CBO looks for cost growth to pick back up in the coming years, putting even more pressure on the budget. Figure 5 Figure 6 Nondefense Discretionary 11.9% Composition of Federal Spending (FY 2028) Other Mandatory 6. Defense Discretionary 10.9% Major Health Programs Net Interest Outlays CBO Baseline Projections Begin in 2018, Percent of GDP Net Interest Expenses: Several of the themes CBO has previously seen driving federal spending higher remain intact Net Interest Social Security Source: Congressional Budget Office and Wells Fargo Securities In addition to increasing mandatory spending, a theme that has become more pronounced this year is increasing net interest costs on the federal debt. As the FOMC progresses along its monetary policy tightening path, higher interest rates will put increasing pressure on the cost of financing the federal debt. As mentioned above, we look for the federal funds rate to reach 3 percent by the end of 2019, and similarly, CBO looks for net interest costs to roughly double as a share of the economy over the next 10 years, growing on average 12 percent each year to reach 3.1 percent of GDP by 2028 (Figure 6). Higher interest rates will push up debt servicing costs, all else equal. But all else is not equal when it comes to federal spending. The budget deal reached earlier this year under the Bipartisan Budget Act of 2018 also has implications for the spending outlook. A key feature of the deal increased the discretionary spending caps instated under the Budget Control Act of 2011 (Figure 7). The 2011 legislation instated caps on discretionary budget authority to rein in federal debt after the August 2011 debt ceiling dispute that ultimately led to a U.S. credit CBO looks for net interest costs to roughly double as a share of the economy over the next 10 years. 3 Congressional Budget Office. (April 2018). The Budget and Economic Outlook: 2018 to Pg. 86. Growth rates calculated from CBO s population projections. 3

4 downgrade. Since that time, Congress has passed a series of spending agreements to lift the caps every few years, with the most recent deal coming this past February. This deal lifted the caps by roughly $300 billion over the next two years, with about 55 percent of this increase reserved for defense spending. Higher spending in 2018 also occurs due to allocated funds for disaster relief in the wake of several hurricanes and wildfires last year, with the $89 billion in funding about nine times larger than the annual average since We expect the increase in discretionary spending that occurred as a result of this deal to boost top-line real GDP growth roughly 0.3 percentage points this year and next, providing additional fiscal stimulus on top of the tax cuts. Figure 7 Figure 8 $350 $300 $250 Increase in BCA Budget Caps Billions of USD Defense Spending Nondefense Spending $350 $300 $250 7% U.S. Discretionary Spending Percent of GDP, CBO Baseline Projections Avg. Defense Spending ( ) CBO Forecast 7% $200 $200 $150 $100 $150 $100 Avg. Nondefense Spending ( ) $50 $50 Defense Spending: 2. $0 FY 2014/2015 FY 2016/2017 FY 2018/2019 $0 Nondefense Spending: 2.8% Mandatory outlays are set to reach roughly 15 percent of GDP by 2028, and this means that fewer dollars are left for a variety of other federal programs. Source: Congressional Budget Office, House Budget Committee and Wells Fargo Securities In the long run, CBO looks for discretionary outlays to continue to decline as a share of GDP. By 2028, both defense and nondefense discretionary spending are projected to fall below 3 percent of GDP, to 2.6 percent and 2.8 percent, respectively (Figure 8). Lower discretionary outlays in the long run partially occur due to CBO s baseline assumption that scheduled reductions to the caps are set to occur in 2020 when the 2018 increases expire. CBO then looks for discretionary outlays to grow in line with inflation through the end of the forecast horizon. Long-term declines in discretionary spending also arise from larger mandatory outlays crowding out discretionary outlays. Mandatory outlays are set to reach roughly 15 percent of GDP by 2028, and this means that fewer dollars are left for a variety of other federal programs, ranging from education and international affairs to housing assistance and infrastructure. For example, we previously wrote about challenges to reforming federal infrastructure programs, partially as a result of limiting funding options. 4 Many of the policy alternatives we discussed, such as deficit spending or further budget cuts, would also apply to other discretionary spending programs, and could be politically challenging to implement. Less funding for these types of programs focused on national investment, such as education and infrastructure, also likely contributes to the slower productivity growth CBO forecasts in the long-run relative to historical averages. Short of an overhaul to the current appropriations process, the difficulty in increasing discretionary outlays above their historical averages will likely continue over the forecast horizon. Revenue Outlook: Tax Collections Below Average Relative to Economy As the tax bill was being debated in Congress throughout 2017, realized federal tax collections as a share of the economy came in quite close to the average over the past 50 years (Figure 9). With the new tax cut bill in place, however, CBO expects federal revenues as a share of GDP to fall this year and next (also Figure 9). With the federal government taking a historically low share of the economy in as tax revenue, lower tax rates should help propel the robust economic growth projections that CBO expects in 2018 and However, the reduction in revenues (and other factors) have led to a widening in the budget deficit late in the cycle. This pattern is historically unusual, as budget 4 Brown, M.A. and Kinnaman, A. (2018). Challenges to Rebuilding America s Infrastructure. Available on request. 4

5 deficits typically expand during recession, gradually close during the recoveries and then begin widening again at the next onset of economic weakness (Figure 10). Perhaps most important to the revenue outlook is that CBO s baseline projections assume current law remains unchanged. Crucially, this includes assumptions that all temporary changes in the tax code lapse as they are set to under current law. While a relatively small number of the recent tax changes expire over the next few years, the big date is December 31, 2025, when the individual tax cuts would expire and a tax increase would take effect the following year. A similar dynamic occurred early in this decade: the 2001/2003 Bush tax cuts were set to expire in 2010 and then were temporarily extended through 2012, before eventually becoming permanent for everyone except taxpayers in the top bracket. Figure 9 Figure Projected Federal Revenues Percent of GDP, CBO Baseline Scenario Projections Revenues: 18. Average Revenues Federal Budget: Deteriorating in an Expansion 4-Quarter Moving Sum, Percent of GDP, Wells Fargo Forecast in Blue Perhaps most important to the revenue outlook is that CBO s baseline projections assume current law remains unchanged % -8% Federal Budget Balance: -3.7% Source: CBO, U.S. Department of Commerce, U.S. Department of the Treasury and Wells Fargo Securities In the most recent Budget & Economic Outlook, CBO provided an additional deficit forecast that is based off of an alternative fiscal scenario. Rather than assuming that current law holds, the alternative fiscal scenario assumes the following: all expiring revenue provisions are extended, the Affordable Care Act taxes that have been repeatedly delayed are repealed, the caps on discretionary spending do not take effect and emergency supplemental spending returns to its historical average. In this scenario, debt held by the public would reach 105 percent of GDP by the end of 2028 the largest share since 1946 and would rise even more sharply in subsequent decades. Were this scenario to unfold, cumulative deficits would be a staggering $14.7 trillion over the next decade, or $2.3 trillion larger than under CBO s baseline scenario. The economic implications of such large and growing deficits would almost certainly be negative. If policymakers tackled these fiscal challenges head on, the tax increases and/or spending cuts needed would likely lead to shortrun economic weakness, a difficult pill for lawmakers to swallow even if there would be long-run benefits. If policymakers simply continued to borrow the money, the risks of a fiscal crisis would rise, net interest costs would likely eat up an ever growing share of the budget and Treasury supply pressures could push interest rates higher and crowd out private investment. For now, tax cuts and higher spending have provided a shot in the arm to growth, but the long-run outlook for potential growth and interest rates is much less sanguine. The Outlook Seems So Bleak: Is There Any Potential Upside Risk? With federal spending expected to see steady growth and projected revenues well short of meeting the shortfall, the fiscal outlook over the next decade is bleak. However, it is important to remember that the risks to the fiscal outlook are two-sided. Downside risks could ultimately prevail: CBO s projections do not include a recession over the next 10 years (as is standard), or health care costs could rise more rapidly than expected. But for the optimists out there, we have asked ourselves: what possible sources of upside risk to the outlook are there? Starting in the near term, nonwitheld individual income tax payments, or taxes paid not directly taken out of a paycheck, topped CBO s The long-run outlook for potential growth and interest rates is much less sanguine. 5

6 expectations in April (Figure 11). Rising equity markets and tax uncertainty were likely causing some delay in capital gains realizations, a phenomenon we noted as far back as last July. 5 When the CBO released its FY 2018 deficit forecast of $804 billion on April 9, we stuck to our $775 billion call with the logic that April tax collections may surprise to the upside, as was the case. CBO s mean absolute error on revenue projections is 5 percent, which would equate to about $175 billion in As we look to next year, CBO s mean absolute error on revenue projections is 5 percent, which would equate to about $175 billion in A hypothetical miss of this size to the upside on tax collections would bring down the projected FY 2019 deficit to $806 billion, almost exactly in-line with this year. Since our economic growth assumptions are more sanguine than CBO s, this is by no means our base case. But, with Treasury s auction sizes already rising to help deal with a deficit of this size, it is plausible a revenue miss of this magnitude to the upside could alleviate much of the need to increase coupon-auctions in Figure 11 Figure 12 3 Nonwitheld Individual Income Tax Receipts YoY Percent Change, Calendar Years, 2018 Is Year-to-Date 3 Growth in Real GDP and Real Potential GDP Year-over-Year Percent Change, Q4 to Q4 2 2 CBO Forecast Nonwitheld Individual Income Tax Receipts: Potential GDP: 1.7% Real GDP: Stronger potential GDP growth would do the most to bring down budget deficits. Source: CBO, U.S. Department of Commerce, U.S. Department of the Treasury and Wells Fargo Securities For the long-run outlook, there are two key possible sources of downward pressure on the budget deficit. First, net interest spending is projected to be the fastest growing category of the budget over the next decade as normalizing interest rates, and a large and growing stock of debt, drive costs. The CBO s baseline projections assume that short-term interest rates (using the three-month T-bill as a proxy) will ultimately rise to 3.8 percent in 2021 before eventually leveling off to 2.7 percent and holding close to those levels thereafter. For the 10-year Treasury, the peak is 4.2 percent in 2021 before eventually reaching a terminal level of 3.7 percent. If interest rates remain below these levels as they have for most of the past decade, pressure from this rapidly growing segment of the budget would ease. Ultimately, however, stronger potential GDP growth would do the most to bring down budget deficits as faster growth leads to more income, profits and ultimately tax revenue. As illustrated in Figure 12, CBO expects potential growth to gradually strengthen as labor productivity growth returns to its average over the past 25 years and the tax cuts improve labor force participation and business investment. The temporary nature of some of the tax cuts and the growing stock of debt eventually outweigh the improvement, however, and potential GDP decelerates modestly. Perhaps the tax bill s impact on long-run growth will be larger than projected, or perhaps a positive shock to total factor productivity will occur as a result of a technological breakthrough, such as artificial intelligence. Absent these possibilities, policymakers will have to grapple with large and rising budget deficits the old-fashioned way: cutting spending and raising taxes. 5 Silvia, J.E., Brown, M. A., and Pugliese, M. (2017). Is Federal Revenue Growth Flashing a Warning Sign? Available on request. 6

7 APPENDIX Wells Fargo U.S. Economic Forecast vs. CBO Baseline Forecast All values are Yr/Yr Percent Change Except as Noted WF CBO WF CBO WF CBO WF CBO WF CBO Gross Domestic Product Real GDP Nominal GDP Labor Market Unemployment Rate (Average) * 3.6 * 4.4 * 4.8 Employment (Avg. Monthly Change, in Ths.) * 62 * 25 * 57 Inflation PCE Price Index * 2.1 * 2.1 * 2.0 Consumer Price Index Core Consumer Price Index * 2.6 * 2.6 * 2.4 Employment Cost Index * 3.6 * 3.5 * Month T-Bill (Average) Year Treasury Note (Average) *A forecast is not available Source: Congressional Budget Office and Wells Fargo Securities Wells Fargo Economic Forecasts for as of February 7, 2018, Long-Range Forecast as of December 2017 Blue Chip Financial Forecast Submission

8 Wells Fargo Securities Economics Group Diane Schumaker-Krieg Global Head of Research, Economics & Strategy (704) (212) John E. Silvia, Ph.D. Chief Economist (704) Mark Vitner Senior Economist (704) Jay H. Bryson, Ph.D. Global Economist (704) Sam Bullard Senior Economist (704) Nick Bennenbroek Currency Strategist (212) Eugenio J. Alemán, Ph.D. Senior Economist (704) Azhar Iqbal Econometrician (704) Tim Quinlan Senior Economist (704) Eric Viloria, CFA Currency Strategist (212) Sarah House Senior Economist (704) Michael A. Brown Economist (704) Charlie Dougherty Economist (704) Jamie Feik Economist (704) Erik Nelson Currency Strategist (212) Michael Pugliese Economist (212) Harry Pershing Economic Analyst (704) Hank Carmichael Economic Analyst (704) Ariana Vaisey Economic Analyst (704) Abigail Kinnaman Economic Analyst (704) Shannon Seery Economic Analyst (704) Donna LaFleur Executive Assistant (704) Dawne Howes Administrative Assistant (704) Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Clearing Services, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. Wells Fargo Securities, LLC. is registered with the Commodities Futures Trading Commission as a futures commission merchant and is a member in good standing of the National Futures Association. Wells Fargo Bank, N.A. is registered with the Commodities Futures Trading Commission as a swap dealer and is a member in good standing of the National Futures Association. Wells Fargo Securities, LLC. and Wells Fargo Bank, N.A. are generally engaged in the trading of futures and derivative products, any of which may be discussed within this publication. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm which includes, but is not limited to investment banking revenue. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company 2018 Wells Fargo Securities, LLC. Important Information for Non-U.S. Recipients For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ("WFSIL"). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. The content of this report has been approved by WFSIL a regulated person under the Act. For purposes of the U.K. Financial Conduct Authority s rules, this report constitutes impartial investment research. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. This document and any other materials accompanying this document (collectively, the "Materials") are provided for general informational purposes only. SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE