Will budget deal cause economy to overheat?

Don Lee, Tribune Washington Bureau on

Published in Business News

The stimulus may give U.S. growth an extra short-term boost, but analysts warn that the additional juice could end up being too much of a good thing.

Jason Fruman, Obama's former economic adviser, tweeted Thursday that "deliberately sending an essentially full employment economy into deficits of 5 percent to 7 percent of GDP is nuts."

The jobless rate is already at a 17-year low of about 4 percent, a level many economists regard as full employment or close to that optimal level before spurring inflation.

Faster growth from the fiscal stimulus will more quickly stretch the labor market's capacity to supply enough workers, pushing unemployment even lower and forcing employers to raise wages to compete for labor.

That, in turn, is likely to increase inflationary pressures and prompt the Federal Reserve to raise interest rates faster to head off a potentially overheating economy.

Higher interest rates will undercut some of the stimulus effects as rising borrowing costs crimp housing activity and other investments, said Mark Zandi, chief economist at Moody's Analytics.

"At the same time you're doing fiscal stimulus, you're doing things to hurt the economy's potential growth," Zandi said. "Interest rates are heading higher. I'd buckle in."

The specter of higher interest rates clearly has set in on Wall Street. The Labor Department's report last Friday showing January's wage growth was the fastest since 2008 suddenly awakened investors to the reality that the long period of very low inflation may be over as the U.S. and global economies are in synchronized expansion, and central banks, starting with the Fed, have begun to pull back on years of monetary support.

As stocks have fallen in the last week, long-term bond yields have surged, indicating investors are expecting interest rates to rise. Higher rates mean businesses, consumers and the U.S. government will have to pay more in interest expenses. And it will make it more costly for the government to finance budget deficits at a time when it needs to borrow more money.

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The Fed recently has begun unwinding its bond holdings, so the U.S. Treasury will have to rely more on domestic and foreign buyers.

To be sure, U.S. debt, particularly Treasury securities, remains a trusted and desirable asset around the world. But America's capacity to borrow as much as it needs -- and at a favorable rate -- isn't assured.

Economists warn that the rising national debt will choke growth as more public money ends up going to support deficits instead of private investments and other economically productive uses.

"You already have deficits growing too fast, you cut the (tax) revenue out from under us, you increase the spending, and on top of that you rule out making changes to entitlement programs," Goldwein said. "It ultimately spells fiscal disaster."

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