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Markets and the deficit: No fear
While Congress debates impact of tax cuts on federal deficit, financial markets focus elsewhere.
December 12, 2005: 2:36 PM EST
By Chris Isidore, senior writer

NEW YORK ( Who's afraid of the big bad federal budget deficit? Not the bond or currency markets.

Congress is debating billions of dollars in tax cuts that may significantly raise the federal deficit. Such a move would typically worry the markets.

That's because federal deficits increase demand for government borrowing, which typically drives prices down and rates up in the bond market. In addition the need to finance a large federal budget deficit usually leads to a weaker dollar, especially when accompanied by large trade gap numbers (which we have now).

But none of that is happening. The 10-year treasury yield was at 4.56 percent on Monday, down from where it was a month ago, despite Congress' budget moves. The dollar has also remained relatively strong despite projections for a higher budget deficit.

What gives? Several economists say they're not surprised. Here's why ...

Changes being debated aren't that large

The AMT relief measure passed last week could add about $31.5 billion to the federal budget deficit in 2006 due to exempting another 17 million Americans from having to pay higher taxes when they file their 2005 taxes.

The House has also passed a $56 billion tax cut over five years to extend some investment tax breaks, such as rates paid on capital gains and dividend income.

But economists say given a global fixed income market that's worth trillions of dollars, that change in borrowing is relatively minor.

"Even though there's a lot of angst over the budget, a cut of $56 billion over five years, or $40 billion in spending cuts over five years, is pretty mild it's almost a rounding error," said Greg Valliere, political economist with the Stanford Washington Research Group.

Budget deficit under control by some measures

There are some forecasts that the federal deficit will rise to $400 billion in the current fiscal year that ends Sept. 30, up from the $319 deficit in the recently completed fiscal year. Still many economists say that is not much of a strain on the current U.S. economy.

David Kelly, economic advisor for Putnam Investments, said that the federal debt is equal to about 37 percent of the nation's gross domestic product. While that's greater than the roughly 33 percent it represented in 2000 when the government was still running a surplus, it's well under the nearly 50 percent level seen in 1994.

And he said that, because current rates are below the levels seen in 2000, the percent of GDP that it costs the federal government to service the debt is at its lowest point since the 1970s.

"While I'd like to see some spending discipline at a time of a strong economy, (the current deficit picture) is pretty much three steps forward, only one step back," said Kelly. "I think the bottom line is the bond market has it right. There's no fiscal crisis in the United States."

That's not to say economists don't worry about federal deficits. But many economists, such as outgoing Fed chairman Alan Greenspan, are more focused on longer-term deficits, such as projected gaps that will be seen a decade or more from now due to Medicare spending increases and social security.

"What's going on with short-term deficit is minor compared to the problem that is looming," said Pierre Ellis, senior economist, Decision Economics. "But if they're ignoring the big problem, it's not surprising they're ignoring the near-term issues."

Inflation, Fed, more important to traders

If bond yields and the value of the dollar move this week, according to economists, it's more likely to be because of signals from the Federal Reserve on the future of its policy of regular quarter-percentage point rate hikes, or a Consumer Price Index report that shows inflation dramatically better or worse than current forecasts.

No one debates that concerns over rising inflation pushes interest rates higher. The Fed has been raising rates steadily since June 2004 in an effort to keep prices stable.

"For long-term rates, I think in order of importance, short rates are the most important thing, inflation is the second most important thing, and the deficit is a somewhat distant third," said Putnam's Kelly.

And the higher short-term rates in the United States, compared to modest central banks rates in Europe and Japan, is one of the factors supporting the value of the dollar versus the euro and the yen. If that gap starts to close, the dollar could lose value even if the federal budget is trimmed, according to economists.

Not all agree deficits heading up

While Kelly, Ellis and some others are forecasting a higher deficit this year, Valliere is telling his firm's clients that the federal deficit should fall below $300 billion in the current fiscal year, even with the hit caused by the tax cuts.

That's because some of the tax cuts being extended in the House legislation don't take effect until after 2008. And even with the AMT change, Valliere said improved tax collections should lower the deficit.

"The big story on the deficit is tax receipts and receipts are surging because the economy is growing faster than expected," he said. "Receipt growth was up by 14 percent last year, and even if it's not up by that much this year, it should be up again."

For a look at the move to extend tax cuts for dividends and capital gains, click here.

For a look at the AMT relief bill moving through Congress, click here.  Top of page

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