Prepared by

Merrill Lynch & Co.

Global Securities Research & Economics Group

In recent testimony to the House Budget Committee, Greenspan shocked bond traders by reverting to the more hawkish stance he exhibited in the February Humphrey- Hawkins testimony (see our Interest Rate Outlook). Going almost unnoticed were the important remarks he made concerning the likely impact of the economy on future tax revenues.

The theme of his testimony was that fiscal circumstances going forward are not likely to remain as favorable as in the past few years. Thus, if Congress is going to ensure that the U.S. remains on a responsible budgetary track, it cannot hope to be bailed out by the one-time- only factors that have helped so much in the past few years. Specifically:

–The reduction in defense outlays resulting from the end of the cold war will not be repeated.

–The added tax revenues from employing both the unemployed and discouraged workers will be limited by constraints to labor force growth.

–Capital gains tax revenues are not likely to keep growing as they have been. Past behavior shows that capital gains tax cuts to be revenue raisers in the front years, but revenue drainers in the out years. Furthermore, the equity market appears to have capitalized for now the impact of beneficial economic factors.

Strong economic growth may continue a while longer. However, the factors that are currently helping to reign in the deficit will be lessened in the future. This means that further attempts to keep the budget in check will require more difficult decisions. Specifically, the aging of the population will force either changes in entitlement programs, further spending cuts, or tax hikes. The sooner Congress and the Administration deal with these problems, the less onerous they will be in the future.

We agree with Greenspan's warnings about the difficulty of maintaining fiscal responsibility going forward. In particular Social Security, the “third rail of American politics” will likely be adjusted to recognize demographic changes (both with regard to longer mortality and the bulge of the baby boomers), and Medicare will likely have to revisited as well, although the recent budget agreement did put it on a better fiscal footing for the next few years.

Despite the longer-term problems that need to be addressed, the near-term budgetary circumstances are still rather favorable. The Congressional Budget Office (CBO) again lowered its estimate to $23 billion from $34 billion, which it released only about a month ago. The CBO went into FY1997 with an estimate of the deficit of $125 billion, but was surprised all through the year by lower outlays for Medicare, Medicaid, and welfare, and much stronger than expected receipts. For the Treasury, the net effect on financing was sharp reductions in the size of bills and short coupons and fewer 10-year note auctions.

The Treasury will have to raise about $45 billion in the new fiscal year to cover the budget deficit. Further, the impact of the capital gains reduction on tax receipts in the coming year is still uncertain. Some forecasters have maintained that due to heavier payments due to “unlocking” of capital gains, the Treasury may even run a slight surplus in FY1998. While this is not our base case, it is true that, in the past four years, the deficit has come in less than forecast every time.

With net debt issuance subdued, the Treasury will also be returning more cash to investors than it will absorb from investors. Investors will receive about $210 billion this year through interest payments (the excess of Treasury interest payments over net borrowing totaled about $180 billion in FY1997, by far a record). Although the excess may narrow through FY01, it should continue to be high at about $160 billion as indicated in the table. That suggests that the supply of Treasuries will be limited in the years ahead.

			FY98	FY99	FY00	FY01	FY02
Net Borrowing# (—)	——45	—52	—48	—36	+32
Net Interest Payment	210	210	200	195	195
Cash for Reinvestment	165	158	152	159	227

# Net borrowing is assumed to equal the budget deficit.

Source–Congressional Budget Office and Merrill Lynch Financial Economics

Another way to look at budget deficits and interest payments is using the concept of the primary deficit. It describes the degree of fiscal restraint built into the federal budget, which may influence the demand for Treasuries. The primary deficit is the total budget deficit less interest payments. As shown in the chart, the balanced budget plan is expected to keep spending in check, which should contribute to maintaining the attractiveness of Treasuries.

(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)

October 16, 1997David Horner

Merrill Lynch & Co.

Global Securities Research & Economics Group

North Tower, 21st Floor

World Financial Center, New York, New York

Financial Commentary

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MYERS ON FUTURES | THE COPPER JOURNAL | COMMODITY FUTURES FORECAST WEEKLY REPORT
INTEREST RATE WATCH | NIKKO MARKET COMMENTS

Consensus National Futures and Financial On Line Index

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