Fiscal Policy and Growth Forecasts Do Not Add Up!
- By Dominique Dwor-Frecaut
- 1 min read
In FY2022, assuming no change to current budget laws, the budget deficit would fall to 4.7% from 13.4% in FY2021. While current budget initiatives, namely the Bipartisan Infrastructure Framework, the American Families Plan/reconciliation package, and the Budget of the United States Government, Fiscal Year 2022 (hereafter the FY2022 President’s Budget) add to budget spending, they are fully funded, i.e., should not change the base line deficit.
Altogether, based on fully funding the bipartisan and reconciliation plans, the budget deficit will likely fall by the equivalent of 9ppt of GDP in FY2022: an outsized, unprecedented fiscal consolidation (Chart 1). I now discuss the likely economic fallout.
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Summary
- The bipartisan infrastructure plan and reconciliation package under discussion are to be fully funded. Therefore, the FY2022 deficit will likely fall to 5% of GDP in FY2022, from 14% in FY2021.
- While private savings will probably fall, they are unlikely to fall enough to fully offset the demand impact of the decrease in the budget deficit: current fiscal policy and growth forecasts are inconsistent.
- In this context, Fed policy normalization is pro-cyclical.
Market Implications
- Flatter curve.
FY2022 Fiscal Consolidation Will Be Unprecedented
In FY2022, assuming no change to current budget laws, the budget deficit would fall to 4.7% from 13.4% in FY2021. While current budget initiatives, namely the Bipartisan Infrastructure Framework, the American Families Plan/reconciliation package, and the Budget of the United States Government, Fiscal Year 2022 (hereafter the FY2022 President’s Budget) add to budget spending, they are fully funded, i.e., should not change the base line deficit.
Altogether, based on fully funding the bipartisan and reconciliation plans, the budget deficit will likely fall by the equivalent of 9ppt of GDP in FY2022: an outsized, unprecedented fiscal consolidation (Chart 1). I now discuss the likely economic fallout.
A High Budget Multiplier Suggests Fiscal Consolidation Will Have a Large Negative Impact on Growth
Budget multipliers (the ratio of the change in output to the discretionary change in fiscal policy) are the standard methodology for estimating the impact of fiscal policy changes, but they are model dependent and a huge literature discusses their estimation.
The IMF proposes a rule of thumb to estimate first-year fiscal multipliers, which I have applied to the US. Based on this rule, the US budget multiplier is 0.7-1. That is, the decrease in the deficit by the equivalent of 9ppt of GDP could decrease GDP by 5.5-9%!
The combination of a decrease in the deficit representing 9ppt of GDP and a fiscal multiplier in a 0.7-1 range seems inconsistent with the CBO forecast of growth accelerating to 6.1% in FY2022. A decline in private sector savings could possibly offset some but not all of the fiscal consolidation.
Bottom line, coming off the exceptional fiscal easing of FY2020-21 without a hard landing will be difficult.
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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.