United States: Back to fiscal uncertainty Global Economic Outlook, Q4 2015

As the US labor market recovers, the big question—in the United States and around the world—is when the US Federal Reserve will raise the federal funds rate. And close to home, political drama once again threatens to upend the ongoing recovery.

After a very welcome but all too short period of fiscal calm, budget and debt battles have once again heated up—not the environment needed to foster business and consumer confidence.


Politically unable to pass a full-year budget, US Congress has once again set the stage for a combined budget/debt ceiling battle, raising the possibility of government shutdown and default on US debt. The temporary budget measure keeps the government funded until December 11; however, in early November, the US Treasury will be unable to make timely payments owed to holders of debt and other government creditors—and this includes Social Security recipients. All this comes as the US Federal Reserve’s (Fed’s) policy-making body, the Federal Open Market Committee (FOMC), has been expressing growing confidence in the strength of the US economy, as it moves to raise interest rates by the end of the year for the first time since 2006. We will need to see how the fiscal drama plays out before we know what is next for the US economy.

Things were actually going fairly well ...

After a slow start in the first quarter, the US economy picked up in the second quarter, giving the first half of the year a solid, but certainly not stellar, annualized growth rate of 2.3 percent—only slightly below the 2.4 percent experienced in 2014 for the year as a whole. As figure 1 shows, while growth in real personal consumption in the first half of 2015 was on par with performance in 2014, performance in the other categories differed more substantially.


  • Business investment slowed considerably in the first half compared with 2014, but the reduction is not as worrisome a barometer of overall business sentiment as it first appears. The softness was concentrated in the mining sector, where the decline in activity caused an actual drop in overall investment in structures and slowed investment in equipment. The third category, investment in intellectual products such as R&D and software, experienced strong growth during the first half.
  • Residential investment is on pace to have the strongest year since the post-recession pop in 2012.
  • The impact of the strong dollar can be seen in the decline in real exports and the increase in real imports. The decline in exports was due to a slowing of goods exports; services exports continued to grow during the first half of the year.
  • The pickup in government spending is due to increases at the state and local level. Real federal spending grew only 0.6 percent.
The labor market also continued to show improvement, with just under 200,000 jobs being created each month, on average.

The labor market also continued to show improvement, with just under 200,000 jobs being created each month, on average. While this is below last year’s blistering pace of 260,000, it is still sufficient to continue to reduce the unemployment rate, which, as of September, stood at 5.1 percent—a rate only slightly above the FOMC members’ estimates of the long-run level.1

However, even with a low unemployment rate, there is considerable slack in the labor market. In addition to the 7.9 million people who are unemployed, 6.0 million people are working part time when they would like to be working full time. Further, there are just under 2 million people who, although they are not working and have not looked for a job in the last four weeks (necessary to be counted as unemployed), have looked for a job in the prior 12 months. As figure 2 shows, the number of people in all three of these categories remains elevated but is trending in the right direction.


With employment improving, what about price stability?

With one aspect of the Fed’s dual mandate, maximum employment, heading in the right direction, the other part of the mandate, stable prices, is proving more difficult to achieve. In 2012, for the first time, the FOMC adopted an explicit target of 2 percent for inflation as measured by the personal consumption expenditure (PCE) price index: If inflation is consistently below 2 percent, then the Fed is limited in its ability to use monetary policy to fight a recession, and high rates of inflation can result in the loss of buying power when income does not keep up with prices.2

Over recent years, PCE inflation has stayed well below the 2 percent target. However, the FOMC has expressed confidence that the forces keeping prices so low are transitory in nature and that prices will rise back to the target level within the next year or so; figure 3 shows the Fed’s disaggregation of the forces keeping PCE inflation so low. Between 2000 and 2007, energy prices were rising faster than 2 percent, but that was being offset by slower growth in import prices and food. During the recession and its immediate aftermath (2007–12), growing slack in the economy—manifested by unemployment that reached 10 percent in 2010—helped pull inflation below the target by about 0.4 percentage points. In 2013, 2014, and 2015, the impact from slack in the economy was dissipating, and falling energy prices and declining relative import prices from the rising dollar forced PCE inflation even lower; it is currently over 1.5 percentage points below the target. Barring something unforeseen, the FOMC expects that “the 12-month change in total PCE prices is likely to rebound to 1–1/2 percent or higher in 2016, barring a further substantial drop in crude oil prices and provided that the dollar does not appreciate noticeably further.”3


Next steps depend on Congress and administration

Although the FOMC chose not to raise the federal funds rate in September, Chair Janet Yellen has given very strong indications that rates will rise before the end of 2015. For example, she noted that, at the September meeting, 13 of the 17 FOMC members said that rates should rise before the end of the year; only three thought they should wait until 2016. (The remaining vote was for 2017.) The move to lessen the Fed’s “overly accommodative stance”—Yellen’s preferred terminology in lieu of “monetary tightening”—should be viewed as a vote of confidence in the US economy.4

With one aspect of the Fed’s dual mandate, maximum employment, heading in the right direction, the other part of the mandate, stable prices, is proving more difficult to achieve.

It is to be hoped that Congress and the administration will be able to act as needed to bolster not only the Fed’s confidence, but also that of businesses and consumers. Either a December shutdown or a refusal to raise the debt ceiling before the Treasury defaults would cause harm to the economy. That Congress will be debating the two issues in the same time period—during a presidential campaign, no less—magnifies the potential for harm. The impact of a shutdown will depend on its duration: The last federal government shutdown was in October 2013 and lasted 17 days, with an estimated cost to the economy of around 0.5 percentage points.5

US_2The suspension of the debt ceiling that had been in place since February 2014 ended on March 15, 2015. At that point, since spending was still outpacing revenues, the Treasury began implementing a series of “extraordinary measures” to continue paying all bills on time without incurring more debt. These measures involve a change in operating procedures in which the Treasury stops redeeming existing and suspends new investments in various funds under its control, such as the Civil Service Retirement and Disability Fund and the Postal Service Retirees Health Benefit Fund.6 The Treasury is currently limited to cash on hand to pay the obligations incurred by the federal government. In his most recent letter to Congress on October 1, Treasury Secretary Jacob Lew stated that they “now estimate that Treasury is likely to exhaust its extraordinary measures on or about Thursday, November 5.”7 Should Congress fail to raise the debt ceiling and the cash is insufficient to pay the bills due on any given day, a queue begins to build, and the payments fall further and further behind. This queue would include Social Security and Medicare recipients, holders of Treasury bonds and bills, military personnel, contractors, and those expecting tax refunds.8 While these direct impacts and the ensuing hardships they would cause are a certainty without an increase in the debt, the great unknown is the amount of turbulence in world financial markets that such an event would cause.

The degree of difficulty in successfully negotiating a budget and a debt ceiling deal was evidenced by the sudden, unexpected decision of House Majority Leader John Boehner to resign effective October 30. Hopefully, the seeds of a deal can be negotiated before he leaves office.