That other macro toolkit
There are two sides to every coin, and two sides to how Washington influences macroeconomic stimulus or restraint. Markets will be hyperfocused on monetary policy as the Fed meets next week, although the direction for the near term seems crystal clear, with only the timing up for grabs. Rates are headed lower, and while we lean slightly towards a quarter point cut now, and a couple of half point moves thereafter, one way or another we’re likely to end up sharply lower in the coming year. The Fed’s “dot” forecast will speak volumes on that front.
But there’s that other toolkit, fiscal policy, which is still up for grabs but rumbling in the background. Deficits got barely a mention in the Presidential debate. House Leader Mike Johnson will end up finding some way to a stopgap bill to keep the government funded rather than see a shutdown right before the election. But at some point, we’ll get down to serious talks about appropriations bills for the fiscal year soon to be underway, and after the election, decisions about the bigger picture for taxes and spending.
As Johnson’s travails show, there are still those in the Republican party who favour spending restraint, and it was Harris who mentioned deficits in the debate. But less clear is whether either party actually wants to restrain deficits. Both Trump and Harris are giving away money to various voter blocs: tip earners in Nevada (from both), first time home buyers (from Harris), and this week, an offer from Trump for tax-free overtime earnings. Much of this finds little support among economists, even those who want to help lower income Americans. Why should two families with the same income pay different tax rates, or receive different benefits, based on whether they earn tips or just salary, work overtime or regular hours, buy their home next year rather than last year or opt to rent, and so on?
Sure, each candidate offers pledges to offset at least some of these gifts with other revenue or spending cuts. For Trump, it’s cuts to the Department of Education, asking Europe to bear more of the cost of supporting Ukraine, or big tariff revenues. Harris pledges tax hikes on items like capital gains (though smaller than Biden’s plan) and top bracket personal incomes. But many of these are either impractical or likely to run into enough opposition in one faction of Congress, whether it’s the Republican caucus now battling with their own party leader in the House, or Senate Democrats who will battle to retain programs.
How fiscal policy will play out can’t really be known until we see the post-election make-up of Congress. But it will still end up mattering to the Fed, and therefore to the bond market. Depending on how they’re financed, sustained deficits at current levels will create funding pressures that could keep long rates elevated, and actually require deeper cuts in short-rates to provide enough juice to mortgage activity. Growing the deficit sharply from here, however, could add fiscal stimulus to the economy, and therefore allow the Fed to ease less. Sharply paring back deficits could be an economic headwind that then necessitates a deeper easing in monetary policy. It’s complicated.
And that complexity also means that the outlook for the bond market is cloudier as we try to project yields deeper into 2025. For now, the prospect that the Fed will at some point start to front-load rate cuts by delivering a couple of 50 basis point moves should keep the bond market happy enough. But we’ll need to keep an eye on that other policy tool kit when a funding deal reached in the days ahead expires, and a full set of appropriations bills is brought back to the floor.
Democrats want to see that scheduled for December, so they can be sure to still be in control of the Senate and the White House, and have a greater sway over spending levels. Spending hawks in the GOP want to push it into the next term of office, which could force more restraint if they gain power in either branch of government. So we’ll soon get a clue, at least on the spending side, of what we’ll face in that other macroeconomic tool kit.
