Last week, UBS economists published an updated view on fiscal policy to 2026, revealing revised deficit projections and insights into their impact on economic growth.
Titled ‘The US Fiscal Outlook’, the report delved deeper into the importance of deficits and their potential effects, including observations on the movements of term premiums following Treasury refund announcements over the past year.
One of the main issues addressed was the expected insolvency of social security within the ten-year budget period. UBS estimates that fiscal policy contributed 1.1 percentage points to real gross domestic product (GDP) growth of 3.1% in 2023. Without such interventions, GDP growth would have been lower, at 2.0%.
Furthermore, UBS learned from their separate analysis of immigration trends that potential GDP growth was boosted to 2.5% in 2023, partly attributable to fiscal policy measures.
“In other words, without fiscal policy, the FOMC would have left real GDP growth in our estimates ½ percentage point below trend, not above,” UBS economists said in a recent note.
“Not only would growth have been a third lower, but by implication employment growth, and the unemployment rate according to typical macro rules of thumb, would also have been a quarter of a percentage point higher. Had that occurred, the FOMC may have been more inclined to view monetary policy as restrictive,” she added.
The note also referenced Fed Chairman Jerome Powell’s 2018 and 2023 speeches in Jackson Hole, where he questioned the “stars,” particularly the r star. The r-star, or neutral interest rate, is critical because it indicates the threshold above which the policy rate is considered restrictive. UBS noted that the r-star also serves as an intercept for monetary policy rules, indicating that the fund rate should already be 100 basis points lower.
According to economists at UBS, these monetary policy rules imply that the policy rate must adjust to the r-star. “The FOMC is thus implicitly behaving as if r-star is higher than the estimated long-term rate they show in the quarterly Summary of Economic Projections, 0.6% in real terms (net of inflation),” they wrote.
The UBS team explained that cutting growth by more than one percentage point would significantly weaken the economy. This weakening would be clearly visible mathematically, with slower employment growth and greater slack in labor markets.
In 2023, the reconciliation of output and hours worked in the private sector indicated that labor market growth was consistent with final demand, or GDP growth. As a result, greater slack in labor and product markets could create greater disinflationary pressures, potentially leading to lower inflation.
“But instead, the FOMC and rate hikes have challenged fiscal policy,” economists said.
“Our expectation is that budget support will decrease, which could make rates look more restrictive,” she added.
