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Has the Fed been fighting fiscal policy?


Last week, UBS economists released an updated outlook on fiscal policy until 2026, revealing revised deficit projections and insights into its impact on economic growth.

Titled “The US Fiscal Outlook,” the report delved into the importance of deficits and their potential effects, including observations on term premia movements following Treasury refunding announcements in the past year.

Among the key concerns addressed was the anticipated insolvency of Social Security within the 10-year budget window. UBS estimates that fiscal policy contributed 1.1 percentage points to the 3.1% real gross domestic product (GDP) growth in 2023. Without such interventions, GDP growth would have been lower, at 2.0%.

Moreover, in their separate analysis of immigration trends, UBS learned that potential GDP growth was boosted to 2.5% in 2023, partially attributable to fiscal policy measures.

“In other words, without fiscal policy the FOMC would have been running real GDP growth ½ pp below trend in our estimates, not above,” UBS economists said in a recent note.

“Not only would growth have been a third lower, but implicitly employment growth too, and the unemployment rate according to typical macro rules of thumb, would have been ¼ pp higher. If that had taken place, the FOMC might have been more inclined to view monetary policy as restrictive,” they added.

The note also referenced Fed Chair Jerome Powell’s 2018 and 2023 speeches at Jackson Hole, where he questioned the “stars,” specifically the r-star. The r-star, or the neutral rate of interest, is crucial as it indicates the threshold above which the policy rate is deemed restrictive. UBS noted that the r-star also serves as the intercept for monetary policy rules, indicating that the funds rate should already be 100 basis points lower.

According to UBS economists, these monetary policy rules imply that the policy rate should adjust in line with the r-star. “Thus the FOMC is implicitly acting as if r-star is higher than the estimated longer-run rate they show in the quarterly Summary of Economic Projections, 0.6% in real terms (net of inflation),” they wrote.

UBS’s team explained that reducing growth by more than a percentage point would significantly weaken the economy. This weakening would be evident mathematically, with slower employment growth and increased slack in labor markets.

In 2023, the alignment of output and hours worked in the private sector indicated that labor market growth was consistent with final demand, or GDP growth. As a result, with more slack in labor and product markets, there could be increased disinflationary pressure, potentially leading to lower inflation.

“But instead the FOMC and the rate hikes have been fighting fiscal policy,” economists said.

“Our expectation is that fiscal support is fading, which could make rates start to look more restrictive,” they added.

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