Thursday, August 09, 2018

Merrill: The Return of the Political Business Cycle

by Calculated Risk on 8/09/2018 01:50:00 PM

A few excerpts from a Merrill Lynch research note:

Political Business Cycle (PBC) models were a hot topic in the 1980s. In the standard "opportunist" PBC model incumbent politicians have an incentive to stimulate the economy going into elections because the benefits-low unemployment-materialize quickly and the costs-high inflation-occur with a lag. ...

After playing a small role in the business cycle in recent years, the political business cycle seems to be making a comeback. The double dose of tax cuts and spending increases at the start of this year marked the first major pro-cyclical policy shift since the 1960s. Coming into the year the US economy was already accelerating, the unemployment rate was steadily dropping further below most estimates of "NAIRU" and the Fed was attempting to reduce monetary accommodation. Despite the strong economy ... the new policies have helped boost the budget deficit, from 3.2% of GDP in 2016 to an estimated 4.7% of GDP in 2019. This would be the largest deficit for an economy at full employment since World War II. The Trump Administration has also rejected its predecessors' hands-off approach to the Fed ...

The market implications of all of this are fairly straightforward. Growing budget deficits combined with Fed attempts to cool the potential serious overheating of the economy means higher interest rates, a stronger dollar and an up-down pattern for the equity market as growth first surges then slows. Much bigger challenges loom in the longer term. At some point the budget deficit will start having a significant impact on capital investment and trend growth in the economy.
emphasis added