On Inflation Recessions and Debt Ceiling Limits
Written by: Larry Eppolito, CFP®
It’s time for some Spring cleanup. The media has been writing incessantly about inflation and a potential recession for over a year now. And lately, the “debt ceiling” issue has been front and center. So, here we go…
The following represents my beliefs.
Inflation peaked at about 9% last June on a “year-over-year basis” (i.e., relative to where it was the year before). It continued to trend down through April as it has for the prior nine months. Inflation was at ~5% in April. It’s been a bit stubborn (and Russia’s illegal aggression against Ukraine didn’t help), but the trend has been down as expected. (1)
The Federal Reserve Bank (The Fed) projects a shallow recession will begin in the third quarter. The Fed’s hope is the recession may help to bring inflation down towards their 2% target. According to a recent Reuters poll of 49 financial economists, inflation is currently expected to be under 3% by early next year, or so. Of course, things can always change. (2)
Client X: Larry, doesn’t the market tend to move ahead of the news?
Larry: Why yes, it does!
Client X: Why then has the market been so resilient in the face of so much recession talk?
Potential for a Recession
As written many times, markets tend to move ahead of the news not coincident or after it. The markets know the Fed is trying to slow the economy. Although the Fed wants to slow the economy, they don’t want to slow it too much. They are trying to engineer a “soft-landing” that re-sets the economy without too much pain.
Although they can be painful, recessions are cleansing. They cleanse the economy of excesses. Thereafter, we hopefully have a long runway of growth in front of us. I believe the markets are currently expecting a shallow recession. Something deeper than shallow would be a surprise and would cause us to endure a deeper downward move in stock prices than currently expected. Keep in mind – we may not suffer a recession. If so, we may have seen the market lows for this cycle. We’ll see.
By the way, what is this “forward-looking market” looking forward to? Answer: Lower interest rates. Although things can change, rates are expected to fall with falling inflation. Lower interest rates are a “tail wind” for economic growth. So, I believe the market is currently looking beyond an expected slowdown to expected growth thereafter.
Potential for a Default on Our Debts
The debt limit, or the “debt ceiling,” is the total amount of money that the United States government is authorized to borrow to fund spending. The current debt ceiling includes all US debt currently outstanding. The US, like most governments, tends to borrow more money each year to meet its growing spending needs.
Remember, Congress “holds the purse strings.” The spending for this budget year has already been approved by Congress. Increasing the debt ceiling does not authorize new government spending. Increasing the debt ceiling authorizes Congress to borrow the money for the shortfall required to fund the already approved spending.
Congress has always acted when called upon to raise the debt limit to accommodate the need to borrow more money. If Congress does not authorize an increase in the debt ceiling, the government will be unable to pay all of its various obligations. The US would be in “default” for not paying interest and principal payments on our government bonds in a timely manner.
First, it’s natural for government spending to grow – as the population grows, the cost of goods and services rises with inflation, the economy grows etc. So, any ceiling is only temporary! According to the US Department of the Treasury, since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents. Although there have been impasses in the past, Congress has always agreed to act before any deadline.
Second, although anything can happen, I believe there is a very low probability of a default. Economists have made clear to both sides what is at stake.
During some previous impasses, Congress has agreed to pass a temporary stopgap spending bill that keeps the government running and suspends the debt limit through the end of the year. The stopgap allowed time for the two sides to get together and negotiate.
Third, if the US was to default, I believe any default would be temporary and, while not good for our reputation, would not be the end of the world. But…
Still, a default is a bad idea. There’d likely be a period of extreme market volatility but again it wouldn’t last forever. The main problem is there’d likely be lasting negative effects to our reputation. Also, the problem with it happening – even once – is future bond buyers will demand a higher interest rate to offset the risk of future defaults even if a default only lasted a short period of time. So, the cost for us to borrow money going forward would rise a bit. Just a bit? Probably. But a small increase in the interest rate the US government would need to pay to borrow money in the future would represent billions of dollars!
Of course, whatever happens, we’ll feel as if we knew “it” was going to happen. Confirmation bias makes many people feel like they knew an outcome would come to pass – even if the potential for a number of different outcomes existed. We all possess this bias, some people more than others. I have this bias, but I try to recognize it and fight it.
The US Dollar
Also, the US dollar holds a special place in the world financial system. Contrary to the dollar narratives coming out of the mouths of many talking heads today (as opposed to credible financial economists), the dollar is not at great risk of being usurped by another currency or a basket of currencies – at least as far as the eye can see. But why give credence to the desire of rogue countries, like Russia, and why tempt fate? This complicated subject is beyond the scope of this letter. If you want more on this, email me for a report that was recently put out by our economists.
Finally, there are only a few weeks between now and what is being called the “X-date” – the date we’d “run out” of money. There is very little time for a deal to be negotiated. I believe this increases the likelihood of an “11th hour” deal to push the debt ceiling limit forward to this fall to give the two sides time to negotiate something that is useful and lasting.
- Inflation has been trending lower. Many economists believe inflation will trend back down below 3% within the next year.
- We may have a recession; we may not have a recession. I believe the markets have already adjusted to an expectation for a shallow
- Although things may change, I believe the markets are looking beyond the next few quarters to an expectation for lower interest rates in our future.
- I believe we’ll reach an 11th hour deal to extend a debt limit agreement to this fall to give both sides time to work out a practical budget deal for the future.
Please feel free to email or call me with any questions.
Summer is just around the corner!
Eppolito Financial Strategies, LLC. is not a registered broker/dealer, and is independent of Raymond James Financial Services. Investment advisory services offered through Raymond James Financial Services Advisors, Inc.
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