In a note published earlier this week, Bank of America economists examined why fiscal momentum is fading despite large deficits remaining.
The bank’s latest US Economic Weekly notes that the slowdown in private and public investment growth in the first quarter of 2024 indicates that last year’s significant fiscal momentum is now fading.
“We were not surprised by this development as we had maintained that fiscal impulse was likely to become roughly neutral this year,” economists said in a note.
A common question clients raise is why fiscal policy does not continue to support economic growth given the “unsustainable” deficit. In an attempt to address these issues, BofA clarifies that “the level of GDP is related to the size of the deficit, but GDP growth is a function of the change in the deficit from the previous year.”
“We think the confusion arises because deficits are widely viewed as a flow variable, but GDP is sometimes mistaken for inventories when in fact it is also a flow,” the economists add.
They further explain that large deficits do not necessarily lead to continued economic growth. Typically, significant fiscal expansion leads to higher GDP levels. However, if the deficit remains stable or subsequently declines slightly, the impact of fiscal policy on GDP growth (fiscal impulse) could change from strongly positive to flat or even negative.
Citing remarks from Fed Chairman Powell, the current fiscal path may be “unsustainable,” but that does not mean fiscal policy remains expansionary, the BofA team explained.
Illustrating the point, BofA points to the primary deficit-to-GDP ratio, which is now eight-tenths below the same period a year ago, “suggesting that federal fiscal policy is holding back growth despite elevated deficit levels,” the bank said. said.