Bank Of America Sees Material Deterioration In Budget Deficit Estimates, Worried About Fiscal Tightening Post Mid-Terms

A few days after the economists have had some time to digest the latest GDP numbers, the results are coming in, and they aren't pretty... And to Obama's chagrin they aren't going to get any better. The end of the stimulus "sugar high" is approaching, and most likely will culminate with the mid-term elections: the attached piece by BofA only solidifies this observation. Bank of America, after Goldman, is now the latest major bailed out bank to join the bandwagon decrying US fiscal insanity (oddly enough, few have much to say about the lunatics in charge of monetary matters). And that's just for the medium-term. Speaking of lunatics, for those curious about the long-term, who can summarize it better than the Oracle of Constitution Avenue himself: "Unfortunately, we cannot grow our way out of this problem. No credible forecast suggests that future rates of growth of the US economy will be sufficient to close these deficits without significant changes to our fiscal policies." - none other than B.S. Bernanke. Furthermore, this is the real problem, forget all about G-Pap reelection chances (none to negative): Greece is just a pleasant distraction compared to what would happen if the US can't roll $700 billion in short-term debt each month.

The following piece by BofAML economist Michael Hanson should probably be read by everyone, but mostly by BofAML head cheerleader David Bianco.

Budget buster

It was an uneventful week, but our core convictions continue to unfold according to script. First: an above-consensus, above-trend economic recovery. US GDP grew at a 3.2% annualized rate in the first quarter, despite unfavorable weather conditions and concerns over a payback for the 5.6% annualized gain in 4Q. Second: core inflation measures continue to drop this year and next. Along with the 1Q GDP data, the Bureau of Economic Analysis reported that the core PCE price index rose just 0.6% at an annual rate, well below the Fed’s implicit target. Third: the Fed is on hold until early 2011. The FOMC reiterated its commitment to keep rates “exceptionally low” for an “extended period.”

Deteriorating deficit outlook

The Treasury’s quarterly refunding announcement next week and the looming threat of a sovereign debt crisis in Europe provides us an opportunity to revisit our deficit projections. After all the US budgetary situation for FY 20091 was nothing to brag about: the federal deficit hit a peace-time peak of $1.42 trillion — nearly 10% of the nation’s output. After sifting through the administration’s most recent budgetary initiatives and current Congressional plans, the FY 2010 deficit now looks to be over $1.34 trillion — somewhat above our earlier estimate of $1.25 trillion (Chart 4). That translates into a budgetary shortfall equal to 9% of GDP.

A sizable proportion of these deficit figures are driven by one-time expenditures to stabilize the economy. For example, the 3.6% growth in consumer spending for 1Q 2010 was supported, in part, by transfers to households. Continued targeted fiscal “stimulettes”, designed to build a bridge to a sustained and broader recovery, are likely to add to next fiscal year’s shortfall as well. Yet the biggest contributor to future deficits isn’t spending: indexing the alternative minimum tax and holding the line on the Bush tax cuts for lower- and middle-income individuals will take an increasingly larger bite out of revenues.

Adding these factors into our projections implies a noticeably worse FY 2011 situation: a deficit of $1.17 trillion, or 7.5% of GDP, versus our earlier projection for a shortfall of $825 billion. We expect the deficit as a share of GDP to  decline as the economy returns to full health, but we still see an average deficit/GDP ratio of 5% from 2012 to 2015, and 4.5% from 2016 to 2020 (Chart 4). No wonder investors are casting nervous glances away from the drama in Europe to worry about the long-run sustainability of the US fiscal outlook as well.

St. Augustine’s plea

Unquestionably, the US government needs to divert the country from its current path to perdition, in our view. But we believe atoning for the country’s fiscal sins should probably wait until the economy is robust enough to handle the penance. We believe policy makers in the administration and at the Federal Reserve are keenly aware of the lessons from Japan’s Lost Decade(s) and the US in the 1930s: don’t prematurely cut the fiscal lifeline to the economy. One of the risks to our medium-term growth outlook would be significantly tighter fiscal policy after the midterm elections. We believe a plan for austerity should be in place soon; the actual austerity should probably begin in earnest in a couple of years’ time. [sorry BofA, as much as politicans want their cake and staying in office too, people are just sick and tired of bankers like you taking the fiscal "stimulus" and converting into nothing but another year of record bonuses. Unlike you, we believe the bitter pill of austerity should be taken yesterday... And no, the world won't end if BofAMLCFC is restructured.]

Even after the effects of the recession on the budget fade in the next year or two, the outlook remains for sizable deficits as far as the eye can see. As a result, US government debt levels will rise as well. Unfortunately, even shifting the structural budget (that is excluding interest) into balance won’t be sufficient to stabilize the debt as a share of GDP. Interest payments on the stock of existing debt continue to mount. The proportion of outlays devoted to net interest payments should account for nearly 6% of total outlays in FY 2010. Given our budget outlook shown in Table 3, that share should exceed 10% in 2014 and 15% in 2020. Stabilizing the debt-to-GDP ratio would require nominal output growth to be at least as large as the interest rate on the debt. As Table 3 suggests, this condition — whether stated in real or nominal terms — is unlikely to be satisfied in the outyears of our budget projection period. Add back in the chronic structural deficits we currently expect, and even faster growth (or lower rates) would be necessary.

That seems unlikely, especially as post-bubble sectoral reallocations and demographics point to a slower rate of trend growth for the US economy over the next decade — on the order of 2¼ to 2½ percent per annum — relative to the last one.

Chairman Bernanke, speaking before the National Commission on Fiscal Responsibility and Reform on April 27, summarized the dilemma well: “Unfortunately, we cannot grow our way out of this problem. No credible forecast suggests that future rates of growth of the US economy will be sufficient to close these deficits without significant changes to our fiscal policies.” Any economists worth their salt will admit that both spending restraint and higher taxes will be necessary to resolve the US fiscal situation.

Borrowing rebalances

Even though we see a wider federal deficit for FY 2010 and 2011, we continue to expect the 10-year Treasury note yield to finish the year at 4.25%, roughly 50bps from where it is now. Several factors support our current interest rate outlook:

1. A modest economic recovery, subdued inflation backdrop, and a zero Fed funds rate are not exactly the recipe for surging government bond yields.

2. The US is home to the world’s reserve currency, and deepest and most liquid capital markets. The ongoing sovereign debt crisis in Europe implies US Treasuries will enjoy a flight-to-safety premium. Indeed, in times of global
crisis, Uncle Sam’s borrowing costs typically head south.

3. Treasury coupon auction sizes have likely peaked. Despite the large fiscal deficit, Treasury coupon issuance is already so large that the US Treasury is likely to decrease auction sizes fairly soon. Our rates strategists think that
could be announced at the May refunding.

In the long run…

In the current hyper-partisan political environment in Washington DC, we believe the risk remains that only a crisis will force the compromises necessary to appropriately deal with the deficit problem in an economically sound manner. One can only hope that the recent turmoil in Europe will strengthen the backbone of US policy makers to fashion a solution before the cost of inaction rises even further.


Well said: to this we can only add that one can only hope that bankers will grow some backbone to tell the truth about the catastrophic US economic situation instead of just continuing the broken status quo model of perpetual sweeping of all problems under the rug. Something tells us Greece would have been a little happier now if they had confronted problems in real time instead of pushing everything into the indefinite future. The "indefinite future" is now almost here.