Why is the fiscal impulse fading despite ‘unsustainable’ deficits? BofA discusses By Investing.com

In a note released earlier in the week, Bank of America economists explored why is the fiscal impulse fading despite ongoing large deficits.

The bank’s latest US Economic Weekly noted that the slowdown in private and public investment in Q1 2024 indicates that last year’s significant fiscal boost is now diminishing.

“We were not surprised by this development, as we have been arguing that the fiscal impulse was likely to turn roughly neutral this year,” economists said in a note.

A common question raised by clients is why fiscal policy doesn’t continue to support economic growth, given the “unsustainable” deficits. In attempts to address these concerns, BofA clarifies that “the level of GDP is related to the size of the deficit, but growth in GDP is a function of the change in the deficit relative to the previous year.”

“We think the confusion arises because the deficit is widely understood to be a flow variable, but GDP is sometimes mistaken for a stock, whereas it is actually also a flow,” economists added.

They further explain that large deficits do not necessarily translate into ongoing economic expansion. Typically, a substantial fiscal expansion results in a level shift up in GDP. However, if the deficit remains stable or contracts slightly afterward, the impact of fiscal policy on GDP growth (the fiscal impulse) can shift from strongly positive to flat or even negative.

Citing Fed Chair Powell’s remarks, the current fiscal path may be “unsustainable,” but this does not mean fiscal policy remains expansionary, BofA’s team explained.

Illustrating this point, BofA points to the primary deficit-to-GDP ratio, which is currently eight-tenths below the same period from a year ago, “suggesting that Federal fiscal policy is a drag on growth despite elevated deficit levels,” the bank said.