Years of declining budget deficits coming to a close

Today, the national debt exceeds $18 trillion and is expected to grow as six years of declining federal budget deficits come to an end this year, according to a recent analysis from the Congressional Budget Office (CBO).

Even with a growing economy, revenues coming into the government’s coffers will not keep pace with spending, especially given significant mandatory expenditures. At the same time, today’s tax rates are significantly lower than 50 years ago. In fact, the highest marginal tax rate has hovered around 35% most of the time since the mid-1980s.

The nation’s debt

The total national debt — money owed by the United States and measured by the value of outstanding Treasury securities — was $18.9 trillion as of January 20, 2016, the Treasury Department reported. The nation’s debt has more than doubled since 2007.

Budget deficit to increase in 2016

The federal budget deficit, which represents the shortfall between government revenue and spending for one year, totaled $439 billion — or 2.5% of GDP — in 2015. This represented the lowest level since 2007 and, in percentage of GDP, was below the average deficit over the past 50 years. Fiscal year 2015 was the sixth straight year that the deficit had declined as a percentage of GDP since it peaked in 2009.

In its January 19, 2016 update, the CBO stated that the deficit will increase for the first time since 2009. The projection is for a $544 billion deficit, representing 2.9% of GDP.

Calendar issue

A portion of the increase — about $43 billion — is due to the timing of the fiscal year on the calendar. In 2016, October 1, which is the first day of fiscal year 2017, falls on a weekend. Certain government payments that would ordinarily be made in fiscal year 2017 will be made on the last day of fiscal year 2016. If it were not for the calendar issue, the 2016 deficit would still increase but would total $500 billion or 2.7% of GDP, the CBO noted.

New legislation

The CBO’s January outlook is $130 billion higher than its August projection of $426 billion. The increase is largely due to bills that became law after August, including the retroactive extension of a number of tax provisions.

The deficit would also cause an increase in the national debt to about 76% of GDP by the end of 2016, reflecting an increase of two percentage points compared with last year, the report noted.

Entitlement programs pose challenges for federal budget

Federal spending is projected to rise by 6% this year, largely due to a nearly 7% increase in mandatory spending, a 3% increase in discretionary spending, and a 14% increase in net interest spending.

A significant portion of mandatory spending is Social Security, which is expected to increase by 3% this year. Other major sources of mandatory program spending include Medicare, Medicaid, the Children’s Health Insurance Program, as well as the cost of health-insurance subsidies, which are expected to be 11% higher in 2016 than in 2015, according to the CBO.

Other pressures on the budget include discretionary spending, where discretionary spending for national defense will increase slightly and non-defense spending will rise 4%. The biggest jump is in net interest spending resulting from the rising-interest-rate environment and the fact that the federal debt is growing.

Revenues to rise

Federal revenues are expected to rise by only 4% in 2016. And CBO projections indicate expenditures will outpace revenue for the next decade.

If current laws remain unchanged, the deficit is expected to grow over the next 10 years, and by 2026 it would be larger than its average over the past 50 years, the CBO stated. The budget deficit is expected to increase modestly through 2018 but then rise more sharply, reaching $1.4 trillion in 2026. As a percentage of GDP, the deficit would climb to about 4.9% by the end of the 10-year period.

Entitlement programs remain challenged

Social Security is the largest single program in the federal budget, the CBO points out. As U.S. life expectancy increases, more and more Americans qualify for benefits. In fiscal year 2015, Social Security benefits totaled nearly one quarter of all federal spending. According to CBO projections, Social Security’s trust funds will be exhausted in 2029. At that point, the result would be a 29% reduction in benefits.

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Fed weighs key risks in decision

Comprehending the strength of the U.S. economic recovery from the Great Recession is a priority for the Federal Reserve as it continues to weigh whether an interest rate hike is appropriate and how it may affect future growth.

Rate increases have typically come in response to economic strength. This was the case in 1999-2000, when the Fed raised rates several times to temper inflationary pressure.

The U.S. economy posted robust growth numbers in the late 1990s, reaching GDP growth rates of 4.5% in 1997, 4.4% in 1998, and 4.7% in 1999 (Source: worldbank.org). In the same years, inflation remained fairly tame at 2.3%, 1.6%, and 2.2%, respectively. But the pick up in inflation between 1998 and 1999 caught the Fed’s attention, as did a string of record highs for the stock market, signaling possible “irrational exuberance” in stock prices, a concern that Fed Chair Alan Greenspan had raised in prior years.

The Fed considered raising rates in 1998, but chose not to make a move amid concerns about the impact of global events such as the Asian financial crisis and Russian default.

In 1999, however, the Fed decided to act. From June 1999 through July 2000, the Fed raised interest rates six times. During the period, the federal funds rate went from 4.75% to 6.5%.

On June 30, 1999, the Fed raised the federal funds rate by 25 percentage points to 5.0%.

Amid the rate increases, the stock market corrected. Prices began to tumble in July 1999, and the downturn lasted through October 1999, when stocks rebounded and finished the year with a strong rally.

In 2000, Fed rate hikes continued in February and March, bringing the federal funds rate to its highest level in nearly five years. Initially, stocks held up. The S&P 500 Index rose to 1,493.87, setting a record in March.

However, the issue of inflated stock valuations, particularly in the technology sector, remained a concern. Many stocks in the so-called ‘new economy’ or dot.com segment included start-up companies with weak revenues but generous market valuations. Fears about inflation also emerged when the CPI jumped 0.7% and core CPI rose 0.4% in March.

The dot.com bubble burst in March, beginning with a huge selloff in the Nasdaq. The Dow Jones Industrial Average and Nasdaq both experienced record-setting declines.

The final rate hike for the cycle came on May 16, 2000, with an increase of 50 percentage points to 6.5%. GDP growth slowed significantly in the third quarter.

By the beginning of 2001, the slowdown forced the Fed to reverse course and begin cutting rates. In a hasty retreat, the Fed cut rates by a full percentage point in two moves during January 2001. The Fed would follow with nine more cuts during the course of the year, bringing the federal funds rate down to 1.75%.

As the Fed was frantically slashing rates, the economy and stock market continued on their downward paths. In 2001, the United States entered a recession, bringing to an end its longest post-war economic expansion. The recession was relatively brief, lasting from March to November of 2001. For stocks, however, the consequences were more severe. Large-cap stocks continued to slump even after the economy began to recover. In sum, the S&P 500 Index posted negative results for three straight years: in 2000, amid the rate hikes; in 2001, amid the recession; and in 2002, in the early months of the recovery.

Fixed-income markets, on the other hand, fared better, as bullish conditions for high-quality assets continued.

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