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Late Tuesday afternoon, Fitch downgraded the United States’ credit rating from AAA to AA+, to the surprise of many experts.

This downgrading is the latest domino to fall in what has been a drama filled 2023 for the United States and its divided government.

The United States government was bogged down in a debt ceiling battle earlier this year in May, which sparked initial concern for potential credit downgrading.

During this debt ceiling face-off, Fitch placed the United States’ AAA rating on watch, stating that further insecurity could lead to a downgrade.

However, the government reached a deal in the 11th hour, avoiding a debt default, and calming the nerves of credit rating agencies across the world.

Or so they thought.

For Fitch, this temporary debt ceiling deal clearly did not move the needle very far, as this was just one factor in their decision.

The rating agency released a statement saying, “In Fitch’s view, there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025.”

Initial reaction

A sense of surprise could be felt from experts and pundits alike across the United States on Tuesday.

Former United States Treasury Secretary, Larry Summers took to social media platform X to criticise the decision.

Current Treasury Secretary Janet Yellen said that Fitch’s decision was “arbitrary” and said “Treasury securities remain the world’s preeminent safe and liquid asset, and… the American economy is fundamentally strong.”

Chief economic adviser at Allianz, Mohamed El-Erian added to the criticism.

Alec Phillips, chief US political economist at Wall Street bank Goldman Sachs said, “The downgrade mainly reflects governance and medium-term fiscal challenges, but does not reflect new fiscal information.”

Economist Paul Krugman said the timing of this downgrading was “bizarre”, especially given the recent inflation report and the continued strength of the American economy. 

A recent report noted that United States inflation grew at its slowest pace in over two years, reaching 3% in June. While 3% is still above the Fed’s target goal of 2%, it marks significant progress from the 9% inflation seen in June 2022.

The positive inflation report was followed by a study showing that the United States economy grew 2.4% between April and June, which was significantly above the expected 1.8%.  

A precarious American environment

But not everyone is sold on the underlying fundamentals of the United States economy. 
According to the St. Louis Fed, as of Q1 2023, the United States’ debt is $31.5 trillion, and the interest payments on this debt are nearing $930 billion.

Federal government current expenditures: Interest payments

Along with the rising debt and interest payments, the United States is not out of the shadows of the debt ceiling. In the 3 June debt ceiling deal, the government simply kicked the can down the road. The government faces another looming fight, as they will need to negotiate another deal in January 2025.

The timing isn’t great either.

January 2025 will likely be filled with other political tensions. President Joe Biden will either be preparing to be sworn in for his second term on the heels of a highly contentious election, or there will be a lame-duck administration, as one of his many Republican contenders, led by former President Donald Trump, will be inaugurated at the end of the month.

Fitch’s reasoning

Fitch laid out some of their driving points for their credit rating decision. 

• Erosion of Governance: The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management. In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process. These factors, along with several economic shocks as well as tax cuts and new spending initiatives, have contributed to successive debt increases over the last decade.
• Rising General Government Deficits: We expect the general government (GG) deficit to rise to 6.3% of GDP in 2023, from 3.7% in 2022, reflecting cyclically weaker federal revenues, new spending initiatives and a higher interest burden.
• Medium-term Fiscal Challenges Unaddressed: Over the next decade, higher interest rates and the rising debt stock will increase the interest service burden, while an ageing population and rising healthcare costs will raise spending on the elderly absent fiscal policy reforms.

Ultimately, there is some disagreement about the timing of the rating downgrade. While there have been a slew of positive reports for the United States economy, as mentioned earlier, Fitch still decided there were a number of underlying factors that led to a loss of confidence. 

As many experts mentioned, there will likely be a limited or subdued market reaction to this decision, as the rating of AA+ still falls well within the Investment Grade and iForex ratings, and the United States Treasury Bills are still viewed as one of the safest investments in the world.

But this decision is yet another data point signalling growing discontent and concern over the political system in the United States.

Regardless of strong economic numbers, instability and infighting will continue to hamper the outlook of the American political and economic system.