What would it take for Congress to act if higher interest became a bigger problem?

Investing.com -- Inflation fears have driven a spike in interest rates, and a fiscal crisis is inevitable even if not imminent, say a recent note from Piper Sandler highlighting actions that would be required to address the crisis, including cutting Medicaid and entitlements, retaining/adding payers to the tax base, and reducing government borrowing.

These are all unpopular across the political spectrum and the firm advises investors to work on the assumption that whatever the government does will likely be “weak or irresponsible.”

The United States retains extraordinary advantages like the dollar’s reserve currency status, deep treasury markets, significant taxation capacity, military and geopolitical power, and the ability to stabilise markets via the Federal Reserve. Nevertheless, the possibility of a U.S. Fiscal crisis is no longer considered a fringe concern by serious financial actors.

Among reasons to think that a fiscal crisis is possible, Piper Sandler says, are the fact that public debt as a share of GDP has crossed 100%, while productive workers are aging out of the workforce and entitlements are growing faster than GDP.

“There was an explosion of debt following the GFC and Covid, and now a normalization of interest rates has sent federal interest costs soaring…Today’s enormous deficits are happening in a full employment economy with asset prices in nosebleed territory. The next recession (especially if accompanied by a stock market correction) could send the deficit to rarely seen heights,” the analysts said.

Policy makers’ reactions to the growing burden of interest cost are another sign the U.S. is in the initial stages of a fiscal crisis. Piper Sandler believes the government is relying too much on bills to reduce near-term federal interest costs. President Trump is pressuring the Fed to cut rates, but this doesn’t address the root causes of the budget problems facing the country.

The firm does not believe that either a Democrat or a Republican government will respond effectively to a fiscal crisis. Both parties are loath to cut taxes with corresponding offsets, willing to remove millions of taxpayers from the income tax rolls, and hesitant to cut Medicare and other entitlements.

Any likely policy actions taken by either government will likely lead to a budgetary crisis and higher taxes or both, say the analysts. But while investors tend to think that a divided government is good for the stock market, this is only true when the market doesn’t need anything from Washington.

Piper Sandler believes that if interest rates rise to levels that put substantial pressure on the economy and the federal budget deficit, Congress would probably be roused to action. However, the odds that the actions taken would make the necessary “painful, unpopular compromises” required to meaningfully boost confidence in the financial markets are “almost inconceivable.”

In any case, the firm does not have confidence in the ability of the political establishment to address the underlying factors responsible for these symptoms.

The analysts see the appetite for responsible fiscal policy declining even as the problem gets bigger.