Federal Debt Limit Raise and Its Economic Implications

Washington's agreement to raise the federal debt limit includes a cap on government spending, which adds a fresh headwind to an economy already burdened by the highest interest rates in decades and diminished access to credit.

The tentative agreement crafted by President Joe Biden and House Speaker Kevin McCarthy over the weekend averts the worst-case scenario of a payments default leading to a financial collapse, assuming it is approved by Congress in the coming days. However, it could marginally increase the likelihood of a recession in the world's largest economy.

In recent quarters, federal spending has helped support US economic growth in the face of headwinds such as a decline in residential construction; however, the debt-limit deal is likely to dampen this impetus. Two weeks prior to the debt-limit agreement, economists estimated a 65% chance of a recession in the coming year.

The spending cap presents a new factor for Federal Reserve policy makers to take into account as they revise their own growth and benchmark interest rate projections, which are scheduled to be released on June 14. As of late last week, futures traders had priced in no change in rates for the mid-June policy meeting, with a final 25 basis-point increase anticipated for July.