The Economy: Red Ink and Fed-Think

What leading economists and market strategists think about the Bush Administration's budget deficit and the Fed's rally against inflation

The bill is coming due for the U.S. economic stimulus plan, and it's a whopper. In a report released on July 28, the Bush Administration said the U.S. budget deficit is likely to swell to a record $482 billion in fiscal 2009, a far larger figure than it had previously forecast. According to an Administration official cited in an Associated Press report, the deficit was being driven to an all-time high by the sagging economy and the stimulus payments being made to 130 million households in an effort to keep the country from falling into a deep recession. The $482 billion shortfall would easily surpass the record deficit of $413 billion set in 2004.

But some positive signs may be emerging in the Federal Reserve's battle against another economic foe—inflation—as Wall Street economists scale back inflation expectations.

What to make of all this? Here's a roundup of what leading economists and market strategists have recently said about these and other topics, as compiled by BusinessWeek and Standard & Poor's MarketScope staff.

Marc Chandler, chief currency strategist, Brown Brothers Harriman

A month ago, many in the market were talking about the possibility of an August rate hike by the Fed. Such expectations have wilted, and fiscal policy now takes center stage. As expected, the Bush Administration announced its estimate of the FY09 budget deficit at a record $482 billion, vs. a projected $407 billion back in February.… Slower growth means lower tax revenues and higher countercyclical spending, and the Bush Administration cut the 2008 growth forecast to 1.6%, vs. 2.7% previously, and the 2009 forecast to 2.2%, from 3% previously. In addition, the cost of the $168 billion stimulus program is being picked up. Of note, much of the spending for the wars in Afghanistan and Iraq are not included in the estimates, but do in fact show up in actual spending. While the news is not good, the impact on the dollar is likely to be minimal.

Action Economics

The Administration's mid-session budget review now estimates the current fiscal deficit at $389 billion, some $21 billion below the February estimate of $410 billion. However, the fiscal 2009 red ink amount is now projected at a record $482 billion, up $74 billion compared with the prior February estimate of $407 billion.… [The consumer price index] is now seen at 3.8% this year, compared with a 2.7% rate estimated in February. The rate is expected to fall back to 2.3% in 2009, which is slightly above the 2.1% clip previously. The [yield on the 10-year Treasury] note rate was revised down to 4% for 2008 and 4.6% for 2009, vs. prior estimates of 4.6% and 4.9%, respectively. The data are close to what was leaked [in earlier news accounts] and are consistent with market fears of rising borrowing needs.…

David Wyss, chief economist, Standard & Poor's

At Standard & Poor's Ratings Services, we publish our economists' best estimate monthly of where the U.S. economy could be heading.…

However, we realize that financial market participants also want to know how we think things could go worse—or better—than what our baseline scenario calls for.

In our deep-recession scenario, oil prices rise instead of fall as they do in the baseline case, peaking just above $200/barrel early next year. The financial markets remain frozen and foreign investors become scared of a falling dollar and bond defaults. As a result, bond yields have to rise to attract the funds needed to balance the trade deficit. The dollar falls steeply, adding to inflation but helping exports in the long run.… The slumping economy and higher costs of federal retirement and health-care programs hit the budget deficit, which jumps to $412 billion in fiscal 2008 and to a new record in each of the two subsequent years, peaking at $701 billion in fiscal 2010. Weaker revenues rather than higher expenditures cause most of the widening.

Jan Hatzius, chief U.S. economist, Goldman Sachs (GS)

This coming Thursday and Friday are packed with economic data releases. We expect the following themes to emerge: 1) second-quarter real GDP growth of 2.5% (annualized), fueled by tax rebates and an unsustainably large boost from international trade; 2) signs that consumer spending may be decelerating as the fiscal stimulus fades; 3) continued labor market weakness; and 4) stable but soft manufacturing activity. The past two weeks have seen a lot of action, with oil prices down more than $20 per barrel, financial firms staging a spectacular but brief rally, and interest-rate futures vacillating in their assessments of the likelihood of Fed rate hikes. However, the fundamentals of the U.S. economic outlook have not changed much. Housing data continue to show massive oversupply, credit conditions are tight and getting tighter, and the labor market is weakening. We continue to expect very weak economic growth over the coming year.

The good news, such as it is, has come on the inflation side. Alongside the oil price decline, long-term inflation expectations have eased among both households and market participants, undermining—at least temporarily—a key argument of more hawkish members of the Federal Open Market Committee.

David Page, economist, Investec Bank

Equities have been very volatile over the past month, especially banking stocks. Concerns over Fannie Mae (FNM) and Freddie Mac (FRE) prompted Treasury Secretary Paulson to announce a rescue package for the two government sponsored enterprises. This, better than expected Q2 earnings for some banking groups plus a fall of over $20 per barrel in oil prices, have helped markets off their lows. Readings on the economy have been flattered by the effects from the recent tax rebates.

Our judgment is that GDP growth will remain sluggish for a while. While Fed members have talked about the need to raise rates at some point, we consider this to be some way off, especially as wage developments seem to be threatening little in the way of second-round inflation effects.