Charles Steindel

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The Philadelphia Federal Reserve Bank has issued estimates of state coincident indexes for February. This is essentially the last comprehensive snapshot of the distribution of activity prior to the impact of the pandemic. A look at the medium and longer-term developments seems fairly off the point. In the short-term, Arizona and Maine experienced declines from January to February (the fall in Arizona was so modest that in the Bank's report it is chalked up as "unchanged"); Maine was the only state to experience a three-month drop. The coincident indexes depend heavily on labor market data, with some smoothing of current developments. One suspects that bad as the March figures are likely to be, they could well be revised down when the raw information for April gets factored in.

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The Philadelphia Federal Reserve Bank has issued estimates of state coincident indexes for February. This is essentially the last comprehensive snapshot of the distribution of activity prior to the impact of the pandemic. A look at [...]

State Coincident Indexes in February

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The Federal Reserve Bank of Philadelphia’s state coincident indexes were again soft in October.. In the one-month changes, South Dakota led with a .67 percent gain, and Connecticut, Ohio, and Delaware had increases above .5 percent. However, the indexes for 13 states declined, with South Carolina and Michigan both down .4 percent (Michigan saw some pronounced retrenchment in autos, and South Carolina would have been hit by the Boeing strike). Over the 3 months ending in September, 12 states were down, with South Carolina (down 1.4 percent) and Massachusetts (off 1.1 percent) once again at the bottom. Connecticut was yet again at the top, with a 1.7 percent increase, with Over the last 12 months, 3 states were down, and 10 saw increases of less than 1 percent. South Carolina’s index was off by 1.2 percent. Arizona had a 4.9 percent increase, and Connecticut was up 4.7 percent, with 7 others up more than 3 percent.

The independently estimated national estimates of growth over the last 3 months (.55 percent) and 12 months (2.55 percent) appear to be roughly in line with the state numbers.

State Coincident Indexes in October 2024

State labor markets were little-changed in October. The Boeing strike, and Hurricane Milton, triggered statistically significant declines in payrolls in Washington and Florida. There were no other statistically significant changes, not even in North Carolina (which did have a insignificant drop). Nonetheless, the sum of payroll changes across the states was -76,400, a clear amount lower than the independent national change of 12,000.

Three states had statistically significant declines in their unemployment rates in October, and one  showed an increase.  None of the changes were larger than .2 percentage point.  The highest unemployment rates were in DC (5.7%),  Nevada (5.7%), California (5.4%), and Illinois (5.3%). No other state had rates as much as a point higher than the national 4.1%. Alabama, Hawaii, Maine, Mississippi, Nebraska, New Hampshire, North Dakota, South Dakota, Vermont, Virginia, and Wisconsin had rates of 3.0% or lower, with South Dakota at 1.9%.

Puerto Rico’s unemployment rate dropped to 5.4%--lower than both DC and Nevada, and matching California--while the island’s job count grew by 2,300.

State Labor Markets in October 2024

Joseph G. Carson

The new administration intends to pursue an unconventional fiscal strategy. A key aspect of the strategy involves reducing or abolishing non-defense government agencies in order to create fiscal space to make the current tax law permanent, lower taxes even more, and generate extra revenue through an extensive and significant tariff program.

The success of the fiscal policy of the new administration will depend on the reaction of the bond market, which has historically influenced policy changes. Three decades ago, Bill Clinton pledged a stimulus package if he won the election, but upon taking office, he had to shift towards a "financial market strategy" instead. Stimulus spending was abandoned in favor of a deficit reduction plan to prevent long-term interest rates from increasing. Given the imbalance in the federal budget is much larger today, it is crucial for policy decisions to take into account the bond market's reaction, raising the question whether policymakers will heed the advice as they did in 1993.

The odds are in favor of the opposite happening, as the new administration is not inclined to give in to the pressures of the bond market. If bond yields jump sharply, the administration might urge the Fed to intervene, potentially worsening the situation.

**The Federal Budget**

In the fiscal year 2024, total federal spending reached $6.75 trillion, resulting in a budget deficit of $1.83 trillion. Currently, defense budget and social programs are deemed off-limits, as are interest payments. This shifts the attention towards cutting expenses in non-defense discretionary spending.

During the fiscal year 2024, non-defense discretionary spending amounted to approximately $950 billion. Although non-defense spending had stayed stable in nominal values between 2010 and 2019, it surged in 2020 as a result of economic recovery initiatives through additional legislation. Nevertheless, there is a pattern of downward trend in non-defense expenditure even prior to the upcoming Congressional term, with forecasts indicating a decline to 2.5% of GDP over the next ten years as per the Congressional Budget Office. The smallest proportion of such outlays in the past five decades was 3.1%.

Although additional spending cuts may still occur, the meager budget share allocated to these programs indicates that the extent of budget savings is significantly smaller than advertised. Below are some more reasons why significantly cutting non-defense discretionary spending will pose political challenges.

With a budget of $238 billion, the Department of Education provides support to almost 100,000 public schools through its programs.

With a budget of $106 billion, the Department of Commerce supports research and development in emerging technologies such as artificial intelligence.

With a budget of $460 billion, the Department of Agriculture funds many projects in rural communities, including housing, community facilities, and utilities.

With a budget of $275 billion, the Department of Transportation makes billions of dollars in grants to improve and upgrade all types transportation systems.

Non-defense federal spending plays a critical role in the economy by offering assistance to businesses of different scales and types, along with state and local governments and individuals. This does not imply approval of the Federal budget or its spending preferences, but rather recognizing essential elements concerning federal spending and its economic influence.

Furthermore, handling the distributional effects of significantly reducing non=-defense spending will pose significant controversy and implementation challenges. For example, states in the northeast pay more in federal taxes than they receive in federal spending, while various states in the south, as well as a few in the mid-west and southwest, receive more assistance than they contribute in taxes. This raises the question of whether politicians from states receiving the most aid will support legislation that significantly reduces the assistance provided to their constituents. Every state listed that gets more in federal assistance than they pay in taxes voted for the new administration.

Extending the 2017 tax cuts adds another layer of complexity to the new administrations fiscal plan. The Congressional Budget Office projects that prolonging these tax cuts could result in a $4.6 trillion increase in the deficit over the next ten years. To counterbalance this, Congress would need to enact spending cuts averaging more than $450 billion a year, affecting almost half of non-defense spending. Moreover, there are discussions about proposing further reductions in federal taxes.

Implementing a comprehensive and substantial tariff program could lead to increased revenue. However, the effectiveness of this strategy is uncertain, as it relies on the assumption that foreign trade partners will not retaliate. Additionally, foreign entities play a crucial role in aiding the US in meeting its federal borrowing needs, hence implementing a tariff strategy is like informing your creditor that you intend to cease transactions with them but expect them not to demand repayment of your loans.

The tariff plan could potentially create complications for both the economy and the bond market. Significant risks include the possibility of higher consumer inflation, which may raise the expenses of social programs (such as inflation indexation) and widen the budget deficit. Additionally, it could lead to higher interest rates, affecting policy rates accordingly.

The new administration has expressed interest in influencing the Federal Reserve's interest rate decisions and has even proposed replacing the Fed Chair before his term expires in 2026. Unlike other government agencies that report directly to the President, the Federal Reserve is an independent agency accountable to Congress. Altering the Fed's independence would require legislative action, potentially causing disruption in the financial markets. The odds of changing the status of the Fed is minimal, but that does not mean the new administration will not publicly expressing its views, which pose challenges for the Fed and confusion (volatility) in the financial markets.

The new administration faces a specific challenge when it comes to dealing with the bond market, particularly due to the fact that it is commencing with an excessively large budget deficit that is forecasted to grow over the next decade. The sheer size of the bond market renders it impervious to being swayed solely through rhetoric or public persuasion. Irrespective of the new administration's declarations or viewpoints, the bond market will express its position on fiscal policy. Three decades ago, the Clinton administration changed direction when the bond market rejected a stimulative fiscal plan. If the new administration's fiscal strategy indicates larger budget deficits and increased inflation, the bond market's rejection will be more significant than that of 1993.

The Viability of the New Administration's Fiscal Policy Will Be Determined by the Bond Market

Sharmila Whelan

Regardless of who was going to become the next US President, Kamala Harris or  Donald Trump, US debt is headed one way and that is up, it is only a question of magnitude. It is not just the US, globally public debt is rising, led by advanced countries and China. World public debt is forecast to exceed US$100trn in 2024, of which 35% will be accounted for by the US and 100% of GDP 2030 according to IMF forecasts (Figure 1).

241108SW1.jpg

Source: IMF Fiscal Monitor, October 2024 & Westbourne Research

We are witnessing an era of fiscal activism. The drive for a green transition, increased defence spending, costly industrial policies, protectionism, rising income inequality, and heightened socio-economic tensions that are translating into growing support for anti-establishment parties at the ballot box have all spurred greater intervention . But this shift is also about a change in mindset. The invisible hand of Adam Smith’s free market is increasingly being countered by the visible hand of the state. David Ricardo’s principle of comparative advantage—central to specialisation and globalisation—is being eroded by government subsidies and protectionist policies, while individual freedom is challenged by the “nanny state.”

**US debt rising but unlikely to hit IMF forecast**

At the height of the pandemic, in 2020 the US government ran a budget deficit of  over 10% of GDP. The deficit has narrowed since but remains substantial, averaging 7.3% of GDP per annum between 2021 and 2023 and 6% in the current year to September. This compares with a pre-pandemic, 2012 to 2019, average of 5.1%.

The IMF projects an average U.S. budget deficit of 6.7% of GDP p.a through 2030, significantly above the global average of 4.2%. Consequently, U.S. government debt issuance is expected to increase sharply, reaching 132% of GDP by the end of the decade.

241108SW2.jpg

We are not convinced the US public debt will rise as sharply as the IMF is predicting. The direction of travel though is clear. Even if Mr Trump scraps the Inflation Reduction Act, dilutes the Chips and Science Act and ends US financial support for Ukraine the budget deficit will remain significant, if as we expect the corporate tax rate is cut.

The worry is the US dollar role as the global currency is diminishing, and with it, seigniorage. Today the US accounts for 58% of international foreign exchange reserves, down from a peak of 86% in 2Q73 (Figure 3). The point is that if there is a  fiscal crisis it will come from domestic investors abandoning US bonds. They own 77% of outstanding Treasuries. Sustainability is a concern because foreign central banks, which hold U.S. government debt to balance their U.S. dollar-denominated assets and liabilities, may offer more stability than U.S. private investors. Unlike private investors, these central banks are generally less focused on returns and more obligated to maintain balanced balance sheets, making them relatively reliable holders of U.S. debt.

241108SW3.jpg

Source: Federal Reserve St Louis & Westbourne Research

**Europe fiscal pressures to increase**

The European public finances picture is equally, if not more, disturbing. At first glance budget balances and public debt are moving in the right direction. Euro-area government unfunded spending during the pandemic was half that of the US. At the peak in 2020 the euro-area in aggregate ran a budget deficit of 7% of GDP compared with 13.9% in the US. Since the budget deficit has narrowed steadily with euro-area government expenditure as a share of GDP declining from 54% to 49.8% in 2023. This year the IMF forecasts a budget deficit of 3% after 3.6% in 2023.

However, European public finances at the national level are flattered by fiscal spending moving from national government to Brussel’s balance sheet and by massive debt mutualisation. Europe is spending plenty, close to the level of the US. The difference is it isn’t reflected in national government balance sheets and therefore in a straight aggregation of member country budget balances and public debt levels.

Donald Trump winning the US Presidential elections is further bad news for Europe. A forced settlement of the Ukraine-Russian war that irreparably damage US-European-NATO relations and heightens national security concerns will push up Europe defence spending and add to fiscal pressures. Another fiscal crisis is probably inevitable. Timing it is difficult. The probable outcomes for the euro-area though are clear. Either it will lead in the to a full-fledged fiscal union or a breakup of the monetary union.

**Asia fiscal prudence prevails**

Asia is another matter, well Japan aside, and probably now China. Inherently fiscally prudent, Asian governments have been reining in spending to bring budget balances back into control (Figure 4). As it stands the  emergency responses of Asian governments as well as central banks to the pandemic was measured compared with their US and European counterparts. The exceptions are India and China. Asian government budget deficits in the three years to 2023 continue, on average, to be larger than pre-pandemic 2012-19 levels. Taiwanese government’s revenues are outpacing spending, although budgetary surpluses are smaller than in the past.

241108SW4.jpg

Source: IMF, Haver Analytics & Westbourne Research

**In conclusion**

The pandemic might be over but in the current era of fiscal and political activism public debt continues to rise globally. A fiscal crisis is not imminent. However, the downside risks are rising for the US as the dollar’s role as the global reserve and trade currency diminishes. EU public finances are equally worrying even if member county government finances do not reflect it. Asia ex China and Japan remains one of the last bastions of small government where debt sustainability is not an issue.

State Coincident Indexes in February

Summary

Charles Steindel

More Viewpoints

State Coincident Indexes in October 2024

State Labor Markets in October 2024

The Viability of the New Administration's Fiscal Policy Will Be Determined by the Bond Market

In The Era Of Fiscal Activism