US Fiscal Policy

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The rancorous debate over health care reform sucked the oxygen away from other pressing issues before Congress.  The savings from the reforms was seen as a critical part of tax reform. 

The tax reform strategy is the same as with health care reform.  A small group of Republicans, representing both houses of Congress and the Trump Administration, are hammering out an agreement that then will be presented to the House of Representative and Senate.  It is not clear how the missing funding, from the health care reform and the Border Adjustment Tax, will be made up for in the tax reform.  The same split that prevented the majority party from reaching an agreement on health care may hamper an agreement on taxes. 

However, before taxes reform or cuts can be addressed, there are two other pressing fiscal issues:  the debt ceiling and spending authorization.  The debt ceiling (~$19.8 trillion) was reached late in Q1, and the Treasury Department has implemented a series of extraordinary measures that were large developments by earlier administrations dealing with the same issue.

Estimates from the Congressional Budget Office and other bipartisan and nonpartisan groups have estimated that these maneuvers will run out in early-to-mid-October.  A failure to lift the debt ceiling results in the government missing a debt servicing payment.  Typically, in the past, the debt ceiling would be lifted in exchange for some additional spending cuts.

On the face of it, this time may be different because the Republicans have a Congressional majority and the White House.  However, the fissures in the Republican Party are sufficiently profound as to render the legislative branch nearly impotent.  It appears to have passed to measures this year: the confirmation of a Supreme Court nominee and sanctions on North Korea, Iran and Russia.  The bill, which Trump has indicated he will sign,  makes it somewhat more difficult for the President to life.

Treasury Secretary Mnuchin has asked for a clean bill to lift the debt ceiling before Congress’ summer recess.  This is not going to happen.  OMB Director Mulvaney sought riders that would cull more spending.  Investor anxiety spurred by the combination of legislative frustrations and the mixed signals from the administration has been expressed in the T-bill market.  In the early part of last week, for example, the three-month bill’s yield rose above the six-month bill yield.

There is some thought that the debt ceiling hike could be attached to the tax reform or the FY2018 spending bills.  While this seems like a pragmatic approach, the risk is that rejecting tax reform or the FY1 18 budget spurs a largely political problem and a missed debt servicing payment.  The failure to grant spending authorization risks shutting down the government.  President Trump and OMB Director Mulvaney have suggested that there was a “good government shutdown,” and that it would force hard decisions.

In May, a government shutdown was avoided when Congress passed a short-term spending bill that funds the government through September.  It was a bipartisan effort that denied Trump some of his spending priorities, including funding for the wall on the border with Mexico.  Last week, Republicans in House drew on a little-used rule to attach a $1.57 bln funding authorization to a broader spending package, without a separate vote.

The split in the Republican Party is not just between its conservative (Freedom Caucus) and more moderate (Tuesday Group) wings, but also it is divided between the House of Representatives and Senate.  One key difference is that the entire House of Representatives faces election every two years, while a Senator serves for six years.  Despite overall surveys showing Trump’s support has fallen toward 35%, his support among his base remains strong.  One survey found only one in eight of his voters would abandon him now.

Lastly, some observers suggest that if these fiscal issues are not resolved by the Federal Reserve’s September 19-20 FOMC meeting, it could impact its decision.  In particular, many see the September FOMC meeting signaling a formal start to the balance sheet operations starting in October.   While it may not make for good optics, we expected the Fed to proceed as it has outlined, my not rolling over the full amount of maturing Treasuries and MBS ($6 bln and $4 bln respectively in each of the following three months.   Just as the Fed has tried to decouple the balance sheet from high frequency data, it would likely to do so with fiscal policy as well.