U.S. fiscal policy – saving grace or slowing pace?

April 18, 2024
By Patrick Er

The evidence early into 2024 affirms a trend of falling inflation but also shows a resilient economy, especially in the U.S. What has been the cause, and can it continue?

• This specific environment, falling inflation and rising growth with low unemployment, is unique.
• Such an unusual and unique combination of outcomes can only arise because of an expansion in aggregate supply - i.e. an increase in productive capacity. This increase has been driven by targeted fiscal policy, offsetting the impacts of restrictive monetary policy.
• Not since the supply-enhancing productivity boost of the mid to end-1990s ‘Tech Boom’ have markets experienced this unique environment.
• However, as the pace of U.S. fiscal policy looks set to fade, what are the implications for monetary policy and the outlook more broadly?

Fiscal policy – saving grace?

In 2022, the U.S. engaged fiscal policy in a unique manner to impact the supply as well as demand sides of the economy, via the implementation of industrial policies such as the Inflation Reduction Act and CHIPS Act. These policies were introduced to expand industrial capacity and have ‘crowded in’ private investment in critical sectors such as high technology and energy. This has increased the structural capability to produce more goods and services thereby raising supply chain resilience, as highlighted in Figure 1.

Figure 1: Construction of manufacturing facilities rising

Source: US Census Bureau and Macquarie

The increased rate of fiscal spending in 2023, despite the angst around the ‘debt ceiling’ in Q2, also significantly offset the negative impact from tighter monetary policy. The most interest rate sensitive sectors, such as residential investment, had already responded negatively to the intense rate hiking cycle but thanks to fiscal policy, the broader economy did not follow suit as was the case in past episodes.

The role of fiscal policy in holding up the private economy is crucial because there is still a lack of sustainable private spending momentum. Despite real wage growth turning positive, household income levels are still behind general price levels, stress remains high and credit card delinquencies are creeping up. This means jobs market resilience is critical: while slowing wage growth is expected, if job losses rise, income and spending will quickly contract.

Fiscal policy – fading pace?

However, fiscal policy in 2024 is unlikely to expand at the pace it did in 2023, due to rising political frictions, especially in the US, which will likely hinder government spending decisions. Historically, we have seen little appetite for major fiscal initiatives in Presidential election years as campaigning takes precedence. Although a drastic withdrawal of stimulus is not likely, this fading fiscal impulse will likely be a reduced offset to tight monetary policy.

Thus, our outlook for fiscal policy in 2024 is a diminishing rate of fiscal impulse through the year, as highlighted in Figure 2.

And therefore, our base case for 2024 is: a high conviction for inflation to fall back to central bank target ranges and growth to slow significantly during the year, with a mild recession possible.

However, given that fiscal-led rise in aggregate supply is structural, our expected growth ranges widen slightly from -0.5% to +0.5% in 2023 towards -0.5% to +1% in 2024 to acknowledge the longer-term impact of aggregate supply expansion.

Figure 2: Lower growth in government spending to diminish fiscal impulse

Source: US Bureau of Economic Analysis and Macquarie

What does this mean for rate cuts?

The implication for monetary policy in 2024 is that central banks now have a fundamental reason to significantly cut interest rates if they choose to recognise the supply driven inflation decline.

However, if central banks choose to focus on growth and unemployment, existing monetary policy could stay too tight for too long – remember, the yield curve has been inverted for a long time and credit conditions are already tight. The longer overtightening persists, the greater the risk of something breaking in the financial economy, which then tends to cause a recession. This occurred in both the U.S. Federal Reserve (Fed) pauses of 2006/7 and 2000/1 (14 and 10 months respectively) which helped trigger the Credit Crisis and Tech market crashes. Accordingly, if central banks opt to prolong the policy pause, the risk of financial dislocation and therefore a ‘harder landing’ increases.

Ultimately, the looser than expected U.S. fiscal policy contributed to the resilience of the US economy in 2023. However, this fiscal-led resilience may turn to fragility should the fiscal impulse fade, or monetary policy remains too tight for too long.

Investment implications

Against this backdrop, we observe that, in general, market participants are pricing in almost entirely optimistic scenarios with equity indices at all-time highs and credit spreads at close to historical tights.

We see this immaculate outlook as unlikely given the fading pace of fiscal policy and tightness of monetary policy. As such, we stay focused on maintaining elevated levels of liquidity and a defensive mindset favouring duration which can provide attractive yields and a risk offset along with high quality investment grade credit which we expect to be less impacted should we see volatility arise.

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