Easy Does It?

• A deal has been struck to extend the debt ceiling at the cost of only a very manageable austerity turn.
• Germany’s recession may look “technical” for now, but the tipping point for the labour market may not be far.

President Biden and House Speaker McCarthy have struck a deal to extend the debt ceiling by 2 years, in exchange for an austerity turn which looks quite manageable. Details were still missing as of Sunday night, but it seems that federal spending could be cut by only 0.3% of GDP in 2024 relative to the CBO’s baseline. From a medium-term growth point of view, a key element is that the deal leaves the IRA untouched. The Democrats will have to stomach a limited extension of the obligation to work for some recipients of federal aid and a cut to the additional resources allocated to the Internal Revenue Service (IRS) to fight tax avoidance. Unsurprisingly, both parties will have to make do without their respective extreme wings to get this through the line. The timeline is tight, even with the “X date” pushed to 5 June, and we can expect some tense episodes, but Biden and McCarthy probably have the numbers to get it through Congress this week. We note however that the whole debate has focused on a very small fraction of US federal spending. The long-term drift in US public finances remains unaddressed.

The fiscal ramifications of this deal, if confirmed, are unlikely to move the Fed’s macroeconomic outlook. The FOMC will however relish the prospect of not having to reverse course – even temporarily – on Quantitative Tightening (QT) to deal with a failure to agree, even if a catch-up in issuance may trigger some liquidity tension in the short run. Some recent data have put the “pause in June” scenario in doubt. We agree it’s a close call, but some of the positive surprises, such as some signs of rebound of the housing market, look unsustainable. We still think the peak in policy rates has already been hit, even if some further moderation in the payroll data this week would help cement the pause.

Meanwhile, Germany is in recession. The German public may be forgiven for having failed to notice, since the labour market has, at first glance, remained impervious to the downturn. We argue however that the tipping point may not be so far away. More awareness of the deterioration in economic conditions would actually be welcome, as it could tilt the unions towards resuming their “jobs first, wages second” approach and help to tame inflation.