The Federal budget deficit is widening – Why, and does it matter?

Summary

The federal budget deficit has been on a rollercoaster ride over the past few years. The deficit widened from 4.6% of GDP in fiscal year (FY) 2019 to 15% in FY 2020 amid the economic carnage of the pandemic and the enormous fiscal aid distributed in response. The robust economic recovery and expiration of many pandemic-era fiscal initiatives helped push the deficit back down to pre-pandemic levels in FY 2022.

The moderation in the budget deficit ended this year. Today, the federal budget deficit is an eye-popping 8.6% of GDP, or 7.1% of GDP when adjusting for the Supreme Court's decision to strike down President Biden's student loan forgiveness plan. What is driving this deficit widening?

Receipts have fallen from supercharged levels (~19.5% of GDP in FY 2022, near the highs of the 1990s tech boom) back toward their long-run average of 17.4% of GDP. Tax revenues from workers' paychecks and corporate profits have held up well, but declining receipts from capital gains income, surging business tax refunds and falling Federal Reserve remittances have driven much of the 10% decline in receipts this year.

On the outlays side of the ledger, there is no one single driver that has pushed up non-interest spending relative to before the pandemic. Outlays for entitlement programs such as Social Security and the major health care programs, national defense, veterans and several other spending categories have grown at a steady clip.

Interest spending has jumped amid much higher rates. The federal government spent about 1.8% of GDP on interest expense in FY 2019. Through the 12 months ending this June, net interest costs had risen to 2.3% of GDP. The good news is that this remains below the highs seen during the 1980s and 1990s despite a debt-to-GDP ratio that is much higher today. The bad news is that interest costs are likely to keep rising in the near-term as maturing debt is steadily reissued at today's higher rates.

On balance, federal budget deficits in the range of 6-7% of GDP appear likely for at least the next few years. If realized, this would put the annual budget deficit as a share of GDP about two percentage points wider than it was before the pandemic and nearly double the average deficit over the past 50 years.

Large budget deficits may put upward pressure on Treasury yields. A general rule of thumb that emerges from the research literature is that a one percentage point increase in the structural budget deficit is associated with an increase in longer-term yields on Treasury securities of roughly 15-30 bps, all else equal. Higher Treasury yields would in turn increase borrowing costs throughout the economy.

Of course, Congress could act to reign in the projected budget gap, either by increasing tax revenues, reducing spending or some mix of the two. But, the prospects for that seem unlikely between now and the 2024 election in our view, meaning 2025 is perhaps the earliest we might see some meaningful efforts at fiscal consolidation.

Fortunately, the United States' ability to finance these deficits is supported by the world's largest economy, which generates $27 trillion of GDP annually and possesses over $150 trillion of household net worth. The U.S. dollar remains the world's reserve currency with no obvious alternatives in sight, and the market for U.S. Treasuries is the world's deepest, most liquid bond market. These factors seem unlikely to change anytime soon, but the sizable medium- to longer-run fiscal imbalance poses a potential structural headwind for the U.S. economy.

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