Reckless Deficit Spending Could Derail the Bull Run

If you read this blog or listen to my podcast, you’ll notice that I’m generally sanguine about the state of the economy and thus the financial markets, particularly in light of the Federal Reserve’s (Fed) recent pivot to dovish policies. I have a positive outlook for the next 12 months but with one important caveat: The Fed cannot reinitiate rate hikes. Unfortunately, federal deficit spending could be a fresh dry log on the dying coals of inflation.

As I mentioned in my last article, the Fed is projected to lower rates an additional 2 full points from now until the end of 2025, but that is under the assumption that inflation will continue to cool. However, both political parties seem uninterested in fiscal responsibility, and if the new president and congress blow out the deficit next year, they could push inflation back up and the Fed may be forced to reinitiate rates hikes.

Deficit spending under former President Donald Trump averaged $1.39 trillion, granted this figure is skewed because of Covid-19 rescue measures in 2020. If you exclude 2020 as an outlier spending year, then the average budget deficit under President Trump was $810 billion per year.

As a comparison, the Biden/Harris administration has averaged $1.95 trillion of annual deficits, and I think it is fair to assume that Vice President Harris will likely continue the trend. Although Vice President Kamala Harris is technically an unknown, she will likely govern similarly to the current president. While on The View, she was asked: “Would you have done something differently than President Biden during the past four years?” And she responded, “There is not a thing that comes to mind in terms of — and I have been a part of most of the decisions that have had impact.”

The aggressive deficit spending from the last year of the Trump administration through the last three years of Biden/Harris administration have certainly played a role in keeping inflation elevated, and I fear that the era of limited government is officially dead.

This is the first election cycle I can remember where neither candidate has run on fiscal responsibility. Usually at least one candidate will run on a message of fiscal restraint even if it is shallow rhetoric. It’s disconcerting to me that this is fully absent from the national discussion.

The problem here is that deficit spending could stoke inflation. On my podcast episode from September 6, Georgetown economist Michael Strain expressed concern over inevitable “fiscal expansion in 2025” and that the “budget deficit will increase instead of decrease.” He notes that the combination of Fed rate cuts and expanded fiscal spending will likely accelerate the economy which could spark inflation. He told me: “I would encourage Chairman Powell and the Fed to be quite clear that a cut in September doesn’t rule out increases in 2025 if increases are in fact necessary.”

In one sense the economy might surge for one more year if spending surges. But if spending pushes up inflation and the Fed is forced to be hawkish again, then a recession could be around the corner in 2026. My concern is that the system will get one more sugar rush before going into anaphylactic shock.

Now, it is not a guarantee that inflation will surge in the face of excess government spending. It is also possible that we will have a divided government, making it difficult to pass fresh spending bills. I still think the main fight against inflation is over and the Fed runs the greater risk of being overly restrictive which could trigger a recession.

Nonetheless, we should be on guard as a nation of both the long and short-run dangers of deficit spending. We all seem to inherently understand that deficit spending posing the long-run risk of the U.S. government defaulting on its debt, but it is easy to ignore or not even notice the short-term problems. The Fed is already at risk of triggering a recession, but if they are forced to raise rates due to poor fiscal policy, that risk grows exponentially.

If inflation pushes back up next year, the markets will likely start pricing in an eventual economic downturn. This could spell an abrupt end to the bull run.

Disclosures:

Any opinions are those of Andrew Benson and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions ore forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Raymond James is not affiliated with and does not endorse the opinions or services of Michael Strain.