Discussions in Washington regarding federal spending are escalating, increasing the possibility of a government shutdown. According to Goldman Sachs Research, this shutdown would likely have a modest impact on the economy, which in turn could make a prolonged stalemate over spending more likely. Goldman Sachs Chief U.S. Political Economist Alec Phillips explains in his report that while the economic effect of a shutdown would be less severe than that of the debt limit, it also makes it more likely that Congress fails to act in time. Phillips estimates that a government shutdown would directly reduce growth by approximately 0.15 percentage point each week it lasts, or about 0.2 percentage point per week once private sector effects are considered. However, growth would rise by the same cumulative amount in the quarter following the reopening.
The impact of a government shutdown is relatively small compared to the overall federal spending for four reasons. Firstly, only discretionary spending, which makes up about a quarter of federal outlays, would be affected. Mandatory spending, such as Medicare and Social Security, is automatically carried out within established rules by Congress. Secondly, only departments that Congress has not funded would shut down. While none of the standard appropriations bills have passed yet, agencies like the Department of Defense are typically spared from prolonged shutdowns. Thirdly, shutdowns primarily impact the work of federal employees, with little impact on investment or purchases of goods and services. Lastly, approximately 65% of federal employees would continue working during a shutdown due to the essential nature of the services they provide.
Past shutdowns have not caused significant reactions in markets, according to Goldman Sachs Research. After three prolonged shutdowns since the early 1990s, equity markets finished flat or slightly increased despite initial dips. The dollar slightly weakened at the start of prior shutdowns, and the 10-year Treasury yield generally declined. However, concerns over the debt limit led to higher yields across the curve during the 2013 episode. Goldman Sachs Research acknowledges that it is difficult to draw firm conclusions as unrelated events occurring concurrently make comparisons challenging.
Considering the modest economic and market effects, a government shutdown would have little impact on Federal Reserve policy. It may even add incrementally to the arguments for the rate-setting Federal Open Market Committee remaining on hold at its November meeting. A shutdown could disrupt the government’s economic releases, reducing visibility into the state of the economy. However, the Federal Open Market Committee has historically downplayed the significance of government shutdowns.
While there have been numerous close calls and more false alarms than actual shutdowns over the years, the ingredients for a shutdown are currently present, including a slim House majority, a dispute over spending levels, and potential complications arising from various political issues.
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