How the debt ceiling deal may shape the US economy

The debt ceiling fight is history, but economists are just beginning to assess how the deal signed into law last weekend will be felt across the US economy.

While the pact did take a worst-case scenario of default off the table, the medicine to stave off that crisis may sap some power from the economy for months and years to come.

A rush of US debt sales could lead to trading volatility and drain some liquidity from banks. Students that got a break on their loans will see their purchasing power drop when they have to start making payments again. And government spending will see cuts in some areas for at least two years.

The spending caps alone could slash deficits by as much as $1.5 trillion over the coming decade, according to the Congressional Budget Office.

How much all of this will affect a $26 trillion economy is unknown. Many say the effects will be limited.

“It’s definitely not nothing but it is relatively small,” says Gordon Gray of the American Action Forum.

Many experts who spoke with Yahoo Finance in recent days drew a comparison to the 2011 debt ceiling standoff. That year’s deal was the last time such a crisis ended with concrete deficit reduction. It also set the stage for an era of relative government austerity.

One argument from the left – including figures like Josh Bivens of the Economic Policy Institute – is that the effects were profound, with the Budget Control Act of 2011 “largely responsible for the sluggish recovery” from a recession triggered by the 2008-2009 financial crisis.

The effects this time around aren’t likely to be that pronounced, largely because the 2011 law implemented discretionary spending caps that were enforceable for an entire decade. This year’s version has caps — but ones that become much less strict after just two years and could end up cutting deficits by far less than $1.5 trillion.

Another key difference between now and 2011, added Evercore ISI strategist Tobin Marcus, “is just how different the macroeconomic situation is.” Inflation is still high despite a campaign by the Federal Reserve to cool the economy over the last year with higher interest rates.

“That was a period of persistently low demand and zero interest rates coming out of a deep and also very long recession. Right now, if anything, we’re still overheated,” he says.

Potential headwinds

One short-term concern for the economy is what happens when the Treasury begins issuing new debt to replenish its coffers following the debt-ceiling deal. On Monday, funds in the Treasury’s General Account jumped by almost $50 billion alone.

Some say these new debt sales could raise borrowing costs, trigger market volatility and drain cash out of bank deposits at a time when the banking system is still recovering from a period of extreme turmoil.

“I wouldn’t rule out the possibility that it’s kind of an incremental drag on risk assets for the next few months,” says Marcus. “But in terms of big macroeconomic concerns, the likelihood that it causes some sort of major shock seems pretty low.”

A second headwind for the economy could be a student loan provision in the deal that prohibits President Biden from extending his student loan forbearance program after a long COVID-era pause. It requires payments to restart in September.

The Supreme Court is also scheduled to rule on the legality of the president’s effort to forgive up to $20,000 in federal student loans as soon as this month.

The student loan provisions could sap some purchasing power from the economy. But the White House and others have downplayed the effects, with Senior Biden Advisor Gene Sperling recently noting on Yahoo Finance Live that the deal “simply just to put in law what we’d already stated.”

“I do not expect this to be a major macroeconomic event,” he added.

President Joe Biden in the Oval Office.

Over the longer term, a more significant economic effect will almost surely be the spending caps that the deal implements.

Brian Riedl, a senior fellow at the Manhattan Institute, acknowledges that provisions could lead to moderate negative economic effects but says it could be a good thing as the central bank tries to cool the economy as a way of keeping inflation low.

“To the extent that there is even a slight drag, that helps bring down inflation and makes the job of the Federal Reserve easier,” he added in an interview this week.

‘As smooth sailing as ever’

Others note that the effects of the deal reached last weekend will be positive for the economy in the months and years ahead – and not just because it averted default.

The deal lessens the chance of another potential economic disruption from Washington this year with provisions that limit the chances of a government shutdown this fall.

Mark Zandi, chief economist at Moody’s Analytics, has said the deal “is about as good as could be expected when it comes to what it means for the economy.”

Budget hawks also note that the controls on the deficit could have economic benefits for year to come.

Maya MacGuineas of the Committee for a Responsible Federal Budget says the more that can be done to stabilize the debt “the stronger it makes our economy, both in the medium and long term,” citing lower interest rates and less inflation pressure.

“It also makes us stronger from a geopolitical perspective and our national security,” she added.

House Speaker Kevin McCarthy, who helped negotiate the debt-ceiling bill.

It is still possible that the deal reached last weekend could be watered down with Congressional backtracking, as happened with the 2011 deal.

“I think we’re gonna see that the same thing happen here with all the side deals we’re hearing about,” Riedl said.

But until then, he adds, there is a system in place to avoid economic disruptions coming from Washington until after the next election.

“It should be as smooth sailing as ever with the caveat that the spending trends are still risky and scary from a long-term federal budget perspective.”

Ben Werschkul is Washington correspondent for Yahoo Finance.

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