The Debt Ceiling Aftermath: 5 Key Takeaways For Markets

One of Washington, D.C.’s longest running dramas is done this year. For over the hundredth time, the debt ceiling is being lifted (or, rather, suspended) until 2025. Yet the debt ceiling dramatics were about much more than just the debt ceiling. It provided a window into the governing, politics, and economy for the next two years.

Washington D.C. Functions, Even When It Doesn’t

The only other country to have a similar debt ceiling – Denmark – seems to get by just fine with it. The debt ceiling drama is a uniquely American institution. So much performative theater with real-world consequences. Some Treasury bills were trading like junk bonds and Fitch put the United States on a downgrade watch.

No one would view this as a functional way to govern. And yet, there’s a method to the madness. The drama is not a bug, but a feature of governing and forcing bipartisan action.

This debt ceiling episode showed there’s a governing majority to avoid calamity. What’s more, it proved there’s a governing majority to actually do stuff. With political polarization and partisans goading for a fight, the House passed the Fiscal Responsibility Act of 2023 by a resounding 314 to 117 vote, including the support of 67% of Republicans and 77% of Democrats.

The FRA skirts a comical tragedy of a U.S. default and lays the foundation for other must-pass legislation later in the year. This includes a spending caps deal for FY 2024 and FY 2025 that has a sequester enforcement mechanism – an automatic continuing resolution with a 1% cut if all 12 appropriations bills aren’t passed at or below spending levels by January 1.

This governing majority will be put to the test later in the year. In being the crucial majority-making vote in the House Rules Committee to move the FRA to the House floor, Rep. Thomas Massie (R-Ky.) gave a hint to why he supported the debt ceiling package. “The debt limit is a scrimmage match and approps is the Super Bowl. That’s why I’m a ‘yes,’” Massie reportedly told House Republicans. In a tweet, Massie wrote “we can and should control spending more transparently and precisely using powerful Congressional tools such as the upcoming appropriations bills.”

Massie may be less willing to go along to get along on an appropriations process that directly impacts outlays, joining conservative Reps. Chip Roy (R-Tex.) and Ralph Norman (R-S.C.) on the Rules Committee to complicate a governing prerogative.

Still, there’s cautious optimism about the outcome of FY 2024 appropriations, but not without its fair share of dramatics and delays. Just like there was a bipartisan governing majority not willing to go over the debt ceiling cliff, there isn’t a majority willing to leverage a cut in defense spending, something that would happen with a 99% CR. It’s a matter of how powerful this group is compared to the far-right and far-left who are okay with defense cuts (although the left isn’t okay with non-defense cuts that would also ensue beyond the FRA and side agreements).

Again, the drama is not a bug, but a feature of reaching a deal. There may have to be a temporary government shutdown before year end or an experience of a 99% CR early next year to cajole enough members to reach a deal.

Biden And McCarthy Still Need Policy Wins For Their Political Bases

President Joe Biden and House Speaker Kevin McCarthy (R-Calif.) are two of the most underestimated politicians in Washington, D.C. They proved the establishment wrong and each other wrong in reaching a deal.

The two have more in common than they would care to admit. Both are Irish teetotalers with a sweet tooth. Beyond their heritage and diet preferences, the two are relationship politicians with a chip on their shoulders to prove naysayers wrong. Their core ideology is their party. As their parties have shifted, so have they.

Biden and McCarthy need the support of their respective bases to keep their jobs and both have made concerted efforts to bring the extremes into the fold. After the FRA, this means more public fights and giving more red meat to their bases.

McCarthy told conservative radio host Hugh Hewitt that Republicans will use the upcoming appropriations process to “eliminate wokism.” One of McCarthy’s biggest rightwing allies, Rep. Marjorie Taylor Greene (R-Ga.), also known as MTG, noted “we need dessert” from McCarthy for supporting this less than desirable debt ceiling sandwich. What’s that dessert? “Impeachment,” MTG said to reporters. “Someone needs to be impeached.” The pressure is building on the right to impeach Homeland Security Secretary Alejandro Mayorkas for his job on the US-Mexico border. It may have to be a dessert McCarthy gives to his base.

Many progressives are upset with the FRA. In particular, the energy permitting section that approved the Mountain Valley Pipeline and some changes to the National Environmental Policy Act without any changes to transmission lines for clean energy development. To that end, Biden is continuing to provide progressive wins with a robust regulatory agenda. The Biden administration recently issued far-reaching climate and emissions proposals and revamped how the regulatory process is organized in a favor of some more climate friendly standards.

Beyond the public posturing, there may be a frenemy-ship forming between Biden and McCarthy. The lines of communication are officially open between the two. The debt ceiling negotiations provided an understanding of where the two men are in their respective parties. There will be plenty of more drama, but the two are empowered for now to avoid catastrophe and reach a compromise when need be.

Fiscal Policy Plays A Supporting But Minor Role To Monetary Policy On Macro Impact

Despite the heightened attention around the debt ceiling, the real economic power center of Washington, D.C. isn’t on either end of Pennsylvania Avenue. It’s at the Marriner S. Eccles Federal Reserve Board Building on Constitution Avenue. The Federal Reserve Board remains the most consequential institution for the economic and political outlook over the next 1.5 years.

That doesn’t mean fiscal policy doesn’t have a role to play, but it’s a supporting one for monetary policy in impacting the macro environment and seeking price stability. To that end, the FRA rows in the same direction as monetary policy as the Fed continues its quest for a soft landing. The FRA helps – directly and indirectly – the Fed on their rate hikes and not having to take their own extraordinary measures if a debt ceiling deal wasn’t reached.

Directly, the FRA cuts the deficit by some $74 billion by the end of FY 2024, according to the nonpartisan Congressional Budget Office. This, of course, is likely an overstatement due to various side deals and budget gimmicks. But that could have a very modest impact to reduce inflationary pressures. The FRA also puts an end to the suspension on student loan payments after August 30. The Biden administration was planning on doing this already, so there’s no direct CBO score, but it leaves no wiggle room for the administration if it had second thoughts. By some estimates, that saves about $5 billion per month.

Indirectly, just raising the debt ceiling will require the Treasury to replenish its accounts that were nearly exhausted by issuing hundreds of billions in debt. According to a Politico report, this could further constrict bank lending by increasing competition for bank deposits and limiting the amount of bank reserves at the Fed.

Then there’s the Supreme Court that could do some fiscal heavy lifting. There will soon be a decision on Biden’s executive action on forgiving tens of thousands in student loans. A recent CBO score on a congressional disapproval resolution trying to overturn this measure estimated direct spending would decrease by $320 billion this year, well above the direct impact from the FRA.

Monetary policy is the main tool to tackle inflation, but this year has shown that it can be a blunt tool with unintended consequences, like causing a banking crisis. The Fed is at a crossroads over the path forward. Right now, Fed leaders appear to be prepping for a hawkish pause in rates.

This direct and indirect fiscal tightening may relieve some pressure on the Fed in their monetary tightening. But it can also hasten a recession, which brings its own economic and political headaches.

Spending Cuts On Paper Don’t Mean Actual Spending Cuts Or Future Austerity

On its own, the “Fiscal Responsibility Act” is like the “Inflation Reduction Act” in that the title of the bill belies the actual content. On paper, the FRA is the biggest deficit-reducing legislation in a dozen years. The CBO estimates it will cut the deficit by $1.5-2.1 trillion over 10 years. In reality, it’s a modest proposal with plenty of workarounds and budget gimmicks. It also doesn’t portend future fiscal responsibility.

On paper, the FRA cuts non-defense discretionary spending below FY 2022 spending levels. In reality, there’s a side deal to increase discretionary spending on veterans affairs. There are some $54 billion in side-deal “adjustments” that puts the non-defense number outside of veterans affairs just $1 billion below FY 2023 levels. Those adjustments include repurposing Covid-19 and IRS recissions and increasing pre-existing workarounds for emergency spending and changes in mandatory programs.

On paper, the FRA also limits FY 2024 defense spending growth to $886 billion, an increase of $28 billion – or 3.3% – from FY 2023. This increase has upset defense hawks from both parties that see it as a real cut when adjusted for inflation. Senators are working on an agreement to work towards a supplemental spending bill for defense spending, like aid to Ukraine, that won’t count towards the FRA’s defense spending cap.

It’s when Congress gets to specifics of certain cuts or limited growth that there is real pushback on pet priorities. Whether there is room for negotiation or if far-right Republicans hold leadership’s feet to the fire remains to be seen.

Despite the GOP’s so-called “paradigm shift” for Congress on spending, it was mostly focused around non-Republican priorities. It’s no surprise then that House Republicans are pushing a slew of tax cuts at the same time they are arguing about a spending crisis.

House Ways and Means Committee Chair Jason Smith (R-Mo.) is aiming to soon introduce a tax package. Such a package could include trillions in tax cuts. This could include a return to R&D expensing, a return to 100% bonus depreciation, removing the cap on interest deductibility, making expiring business and individual provisions of the Tax Cuts and Jobs Act permanent, and raising the $600 threshold for 1099-K reporting.

It’s clear deficit reduction today won’t get in the way of the GOP’s perennial priority of cutting taxes. Some of these measures even have Democratic support. However, the dynamics remain challenging for getting a bipartisan tax package to pass Congress this year.

The 2024 Election Matters A Lot For Markets

A big policy battle is looming in 2025. Several individual and business tax provisions from the TCJA expire at the end of 2025. For Democrats, the enhanced Affordable Care Act subsidies in the Inflation Reduction Act expire at the end of 2025. Now, the FRA suspends the debt ceiling until the start of 2025, with extraordinary measures pushing it later into the year.

The costs are substantial. The CBO estimated permanently extending the TCJA would cost $3.5 trillion. That could mean substantial offsets.

The direction of policy hinges on the 2024 elections. Unified control of government means there could be a reconciliation bill that passes on a party-line vote. Divided government means there would be bipartisan negotiations. There’s a big difference in the policy menu on offer for taxes (cuts and offsets), spending, and the debt ceiling between Democratic reconciliation, Republican reconciliation, or a negotiated compromise under divided government. Right now, it’s too early to be confident about where the 2024 election is heading, but the FRA only reinforces how consequential the 2024 election will be.