Viewpoints

Due to the repetitive nature of economic and financial cycles, analysts frequently encounter phases that resemble previous cycles. At the December FOMC meeting of 1999, twenty-five years ago, the Fed research staff delivered a provocative presentation, arguing that parts of the equity market (mainly tech and e-commerce) had showed characteristics of a "bubble". How might policymakers respond today if the Fed staff made a similar argument, considering the aftermath of the tech bubble burst 25 years ago and the fact that many equity price metrics now indicate even more extreme valuations?

Will History Repeat?

The notion that predicting an equity bubble before it collapses is impossible has been debated for a long time. Yet, in today's context, can this remain valid when there is clear evidence of fundamental valuations defying basic principles of gravity, along with cases where lower valuations were linked to a bubble?

It's important to mention that Fed staff cautioned policymakers about an equity bubble in the late 1990s. At the December 1999 FOMC meeting, the Fed's director of research noted that "the market has defied our notion of valuation gravity by posting an appreciable further advance." The research director provided an example of a new IPO to illustrate the market's speculative nature and mentioned that analysts were disregarding fundamental analysis because the only thing that seemed to matter was "momentum." He then doubted whether an additional tightening of 75 basis points in the staff forecast would be sufficient to "halt the financial locomotive".

From a market perspective, 2024 differs from 1999. In certain instances, equity valuations today are as high, if not higher, than they were in 1999. For instance, the S&P price-to-sales ratio is over 3 today, compared to 2 in 1999, which at that time was a record. This higher ratio indicates even greater investor optimism or exuberance, suggesting potential fundamental instability as people are paying excessively for future sales and cash flow. Although the IPO market does not exhibit the speculation seen in 1999, there are other signs of market speculation in cryptocurrency and private credit.

Additionally, there is a significant contrast between the monetary and fiscal policies of 2024 and those of 1999. In 1999, monetary policy was being tightened, whereas recently, policymakers have reduced official rates at the last two meetings and signaled further easing. At the same time, fiscal policy was restrictive in 1999, with the US achieving a budget surplus, which stands in stark contrast to the current large budget deficit that boosts domestic spending and liquidity.

Drawing from past experiences and research, it would not be big surprise if the Fed staff made a presentation at the December 2024 FOMC meeting similar to that of December 1999. Essentially, market speculation has reached "bubble-like" levels, skewing resource allocation, pushing the wealth-to-income ratio to unprecedented heights, and posing a major economic threat should there be a significant drop in the equity market. The main question is whether policymakers will heed this warning.

Policymakers have consistently made official rate decisions with a focus on employment and inflation goals, often neglecting their financial stability mandate. It's no coincidence that the recessions since 2000 (excluding the pandemic-driven recession) were triggered by financial imbalances. Any decision to ease policy, or even a promise to ease later, would increase the risk of a harder landing that might be difficult to cushion, unlike in 1999 when the US operated with a fiscal surplus.

Regardless of the actions policymakers decide on, they can no longer ignore a speculative asset price cycle like they did in December 1999. Policymakers are fully aware of the economic and financial losses that come with asset price imbalances. When the tech bubble burst three months later, the Fed spent the next three years lowering official rates to lessen the economic impact of the financial crisis. After the housing bubble burst, the process took even longer. Currently, the Fed is confronting a larger and more extensive financial bubble, with no fiscal cushion to help navigate a severe recession.

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 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.

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.

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).

On Sunday, October 27, 2024, Elon Musk claimed that he could find at least $2 trillion of potential spending reductions in the federal budget if Donald Trump were elected in the upcoming November 5, 2024 presidential election. I assume he could find the same magnitude of budget cuts if Donald Trump were not elected. Well, if Musk can return a rocket to its launch pad, why wouldn’t we expect him to identify $2 trillion in federal budget cuts? After all, in Fiscal Year (FY) 2024, federal net outlays were $6.75 trillion. Surely, Musk could identify $2 trillion of “fat” to trim. Or could he?

Shown in the Chart below are net federal outlays in FY 2024 minus net outlays for national defense, interest payments on the public debt, Social Security, Medicare and veterans’ benefits/services. The amount remaining of net federal budget outlays after these subtractions is $2.3 trillion. That’s $2.3 billion for Medicaid, SNAP (food stamps), civilian retirement, earned income tax credits and the operating /capital costs of nondefense federal departments, including, but not restricted to, Justice, Agriculture and Transportation. So, if Musk had been able to identify $2 trillion of cuts in FY 2024 federal outlays, net of defense, interest, Social Security, Medicare and veterans’ benefits/services, that would have left him with $300 billion to fund the rest of federal outlays. Would you want to fly on commercial airlines knowing that airline regulations might not be enforced? You might want to start growing your own vegetables and raising your own animal protein, because the FDA might not be able to inspect food. Those Venezuelan gangs might be taking over more towns because of a lack of FBI agents to stop them. You get the picture. Unless Musk is going to cut spending on defense, interest, Social Security, Medicare, and veterans’ benefits/services, cutting $2 trillion from federal outlays would not leave enough to fund the rest of the government adequately. And if Musk, as part of a Trump administration, were to cut Social Security, Medicare and veterans’ benefits, the Democrats would likely win large majorities in the House and Senate after the 2026 midterms. So, although Musk can return a rocket to its launch pad, I don’t think he can cut $2 trillion from federal outlays in one year without causing severe political problems for a Trump administration.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in September remained soft. Connecticut was, yet again, on top, with a fairly modest .57 percent increase. New Hampshire was the only other state up more than .5 percent. 11 states saw declines, with Massachusetts, South Carolina, and Montana all down .29 percent. Over the 3 months ending in September, 14 states were down, with Massachusetts dropping 1.9 percent, while South Carolina was also down more than 1 percent. The odd New England pattern was ongoing, with Connecticut was on top with an increase of 1.95 and New Hampshire rising more than 1 percent. Over the last 12 months, 3 states were down, Ohio was flat, and another 8 saw increases of less than 1 percent. Rhode Island’s index was off by .6 percent. Arizona had a 4.99 percent increase, and Connecticut, New Hampshire, Idaho, Texas, and Utah had gains of more than 3 percent (Maine was up 2.98 percent—there certainly has been some odd variation in New England).

The independently estimated national estimates of growth over the last 3 months (.7 percent) and 12 months (2.8 percent) appear to be roughly in line with the state numbers.

State labor markets were a bit firmer in September than in other recent months. Five states, plus DC, saw statistically significant increases in payrolls. New Jersey had the largest absolute gain (19,200), while Idaho saw a .7 percent increase (Texas reported an increase of more than 29,000, but this was seen as not statistically different from zero; the gain was only about .2 percent).

Five states had statistically significant increases in their unemployment rates in September, and one (yet again Connecticut) showed a decline. None of the increases were larger than .2 percentage point. The highest unemployment rates were in DC (5.7%), Nevada (5.6%), California (5.3%), and Illinois (5.3%). No other state had rates as much as a point higher than the national 4.1%. Alabama, Hawaii, Iowa, Maine, Maryland, Mississippi, Nebraska, New Hampshire, North Dakota, South Dakota, Vermont, Virginia, and Wisconsin had rates of 3.0% or lower, with South Dakota at 2.0%.

Puerto Rico’s unemployment rate dipped to 5.6%--very unusually, matching Nevada and a touch below DC--while the island’s job count grew by 3,600.