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The economy isn’t broken, but Washington sure is trying to fix it

Posted at 1:23 PM, Jul 23, 2019
and last updated 2019-07-23 21:39:11-04

America’s economy is in a period of historic prosperity, but you wouldn’t know it from Washington’s policymaking.

The federal government has a long track record of treating recessions by handing out a powerful dose of medicine to bring the economy back to life. Congress and the White House typically rush through massive tax cuts and government spending increases aimed at keeping the economy humming. The Federal Reserve slashes interest rates to encourage businesses and households to spend.

Washington is turning to this strategy again today — even though the economy does not appear to be seriously ill.

The $1.37 trillion bipartisan budget agreement reached on Monday would raise government spending by $321 billion over the next two years. The deal is designed to avert a debt ceiling crisis. And investors believe it’s a slam dunk that the Fed will cut interest rates next week for the first time in nearly 11 years in an effort to bolster inflation and offset trade uncertainty.

Although the economic outlook has darkened — in large part because of the US-China trade war — few economists expect an imminent recession.

The unemployment rate is near 49-year lows, the stock market has never been higher and consumers are spending. That’s not exactly the backdrop that would normally require the Federal Reserve and Congress to come to the rescue.

“Washington is giving antibiotics to a healthy child. That’s just bad medicine,” said David Kelly, chief global strategist at JPMorgan Funds, in an interview with CNN Business. “We will look back and think about how irresponsible and adolescent we were to use every piece of monetary and fiscal ammunition to boost an economy that was doing just fine.”

No rainy day fund

Normally, the Fed and Congress would have used these good economic times to build up ammo to fight the next recession. That means cutting the budget deficit and raising interest rates.

“This is a time when you should be preparing yourself for a rainy day,” Kelly said. “But we’re not doing that, so we will be poorer in the long run because of it.”

Kristina Hooper, chief global market strategist at Invesco, called Washington’s dual-pronged response to economic prosperity “bizarre.”

“It’s almost Twilight-Zone economics. It doesn’t fit with where we are in the economic cycle,” Hooper said.

To be sure, it’s a short-term positive for the economy and markets that Trump and Congressional leaders appear to have averted a budget crisis. The budget agreement, which still needs to be passed by Congress and signed into law by Trump, calls for suspending the debt limit until July 31, 2021.

However, the overall trajectory of the budget remains in alarming shape.

$1 trillion deficits on the horizon

The Congressional Budget Office has projected the federal deficit will hit $895 billion in 2019 and climb above $1 trillion by 2022.

Many economists have applauded President Donald Trump’s desire to make Corporate America more competitive by lowering corporate taxes. However, the 2017 tax overhaul added to the federal deficit, sapping the government of revenues during a strong economy.

Relative to the size of the economy, the CBO projects the deficit would average 4.3% of GDP between 2020 and 2029. The CBO said that besides just after World War II, the only other time the average deficit was so large over so many years was after the Great Recession.

In times of economic prosperity, the US government moves toward a balanced budget.

“It’s a bipartisan debt binge,” said Danielle DiMartino Booth, CEO and chief strategist for Quill Intelligence. “It’s sad that we’re running up a trillion dollars of debt every year and have so little to show for it.”

JPMorgan’s Kelly said that there have only been two years in the past 71 when the budget deficit as a share of GDP has been above the unemployment rate: 2009 and this year.

The nonpartisan Committee for a Responsible Federal Budget estimates that the agreement will add about $1.7 trillion to the federal debt over the next decade. If the deal passes, CRFB said that discretionary spending will have climbed by as much as 22% over Trump’s first term.

“It may end up being the worst budget agreement in our nation’s history, proposed at a time when our fiscal conditions are already precarious,” Maya MacGuineas, the group’s president, wrote in a statement.

Here comes the Fed

Meanwhile, the Fed is preparing to lower interest rates — a strategy that officials have likened to taking out “insurance” on the economy.

In recent public appearances, Fed chief Jerome Powell has downplayed positive developments and emphasized soft inflation, trade tensions and turbulence in foreign economies.

Some believe that looming rate cuts — investors are pricing in at least three rate cuts by the end of the year — are justified by these concerns as well as red flags in the bond market.

The yield curve has inverted, meaning short-term rates are below long-term rates. That has been a reliable recession indicator in the past and a signal that the Fed has raised rates too aggressively.

“The longer this inversion persists, the more damage is done to the economy,” said DiMartino Booth, a vocal critic of the Fed who previously worked at the Federal Reserve Bank of Dallas.

The economic data has been mixed. While the unemployment rate is low and retail sales are strong, manufacturing activity has stalled under the crushing weight of tariffs. Some regional manufacturing surveys have recently rebounded, although the Richmond Fed’s manufacturing index released on Tuesday tumbled to a six-year low.

“Economic conditions aren’t spectacular, but they aren’t bad either,” said Guy LeBas, chief fixed income strategist at Janney Capital Markets.

LeBas said he doesn’t believe the latest economic metrics, financial market action nor inflation rate justify a rate cut.

“I think John Maynard Keynes would roll over in his grave, get up and smack Jay Powell in the face,” LeBas said, referring to the famed economist who advocated for government intervention to halt recessions.

Jan Hatzius, chief economist at Goldman Sachs, wrote in a report on Monday that the “justification for rate cuts at the current juncture is tenuous.”

Insurance isn’t free

Still, the Fed has little choice but to lower rates, because it has allowed markets to price it in already. Failing to act could create market mayhem that spills over into the real economy.

However, there are risks involved with prematurely lowering rates. Hatzius warned that with financial conditions “already very easy” further rate cuts “could raise financial stability concerns down the road.”

In other words, the Fed could inflate an asset bubble by forcing investors to take risks to generate returns.

“It’s not costless to take out insurance,” Boston Fed President Eric Rosengren, a voting member of the central bank, told CNBC last week. “You pay a premium for the insurance. And one of the ways that you think about that cost is what you’re doing to financial stability.”