As we step into the fourth quarter of the year, the United States is facing an array of challenges that could significantly impact its economy. We’ve previously discussed these headwinds, including the depletion of pandemic-era savings, tightening lending conditions, soaring energy costs, and the resumption of student loan repayments. Now, another formidable obstacle looms on the horizon - the possibility of a government shutdown on October 1. In this article, we will explore what this means for the nation and who stands to be affected.
Government Shutdown: A Recurring Threat
Government shutdowns are not a new phenomenon in the United States. Since 1981, they have occurred 14 times, with varying durations. While some shutdowns have lasted just a day or two, the longest stretched for 34 days between December 2018 and January 2019. Typically, these disruptions last around one to two weeks before politicians reach a funding agreement.
During a government shutdown, government agencies cease operations, hundreds of thousands of government employees and private sector vendors go unpaid, and economic data flow is obstructed. The economic impact is somewhat cushioned by the eventual back-pay government workers receive. In fact, the Office of Management and Budget estimated that the 16-day government shutdown in 2013 reduced the GDP growth for the third quarter of that year by approximately 0.3 percentage points.
The Threat of an Extended Shutdown
However, the current situation presents heightened tensions, and the proximity of the next Presidential election adds an element of uncertainty. While both parties agree on the need to reduce government spending deficits, Democrats favor tax increases, while Republicans advocate for significant spending cuts. Funding for Ukraine further complicates the situation. Additionally, the narrow Republican majority in the House and the reluctance of hardliners to compromise further intensify the challenge.
If no funding is allocated, over 800,000 workers could be furloughed without pay. Essential federal government workers, including Homeland Security, prison staff, military personnel, and legal workers, would be required to continue working without compensation. National parks and museums may close, affecting businesses in their vicinity, and federal government contractors could face delayed or lost payments. Overall, consumer and business sentiment would suffer, leading to weakened spending.
A rule of thumb is that each week of a shutdown shaves off 0.1-0.2 percentage points from quarterly annualized GDP growth. If a prolonged shutdown extends into early December, it could dent GDP growth by nearly a full percentage point. Given that consensus expectations for fourth-quarter annualized growth are only 0.4%, this would increase the risk of a negative GDP print for the quarter.
Impact on the Federal Reserve and Financial Markets
Such an economic outcome would undermine the justification for the Federal Reserve’s planned interest rate hike in either November or December. Even if the shutdown is brief, it could disrupt data flow, casting doubt on data quality and reliability. The October jobs report, completed in the week of the 12th, and CPI could be particularly vulnerable.
The lack of economic clarity could lead to the Fed maintaining interest rates, giving room for the anticipated economic slowdown to materialize. Core inflation’s continued moderation would further support the argument that the Fed’s hiking cycle is already over.
Financial Market Dynamics
Unlike the debt ceiling debacle, which threatened a technical default and instability in financial markets, a government shutdown does not pose a risk to the payment of interest or redemption on government debt. The Treasury can continue to issue debt to raise cash. However, it lacks the legal authority to spend beyond the end of September, impacting parts of the government covered by specific spending bills.
The impact on financial markets primarily centers on its dampening effect on economic activity, which should push Treasury yields downward. Risk assets may also face uncertainty, leading to a shift of funds into bonds and money market funds. Importantly, there is no substantial default risk for Treasuries, ensuring the stability of the financial system.
As October 1 approaches, the United States stands at a pivotal juncture. A government shutdown, if prolonged, could have significant repercussions for the economy, the Federal Reserve’s policy decisions, and financial markets. While history has seen such shutdowns resolved relatively quickly, the current political landscape suggests a more extended period of uncertainty. The nation will be closely watching, as this date may indeed become the deciding factor for America’s near-term fate.