U.S. lawmakers must make credible progress this year on a long-term deficit-reduction strategy or risk losing Fitch Ratings' top AAA grade on U.S. government debt, Fitch warned Wednesday.
Fitch said it would not immediately cut its rating if Congress fails to stop $85 billion in automatic spending cuts from taking effect Friday, or even if there's a partial government shutdown later.
But a repeat of the 2011 crisis over raising the debt ceiling also could provoke a downgrade, Fitch said. The U.S. is scheduled to reach the current debt ceiling in mid-May, but the Treasury Department could take measures to extend its borrowing authority for another two or three months.
A downgrade by Fitch would make two out of three major credit rating agencies to knock U.S. off the top rung of the most credit-worthy nations. Standard & Poor's cut its AAA rating on U.S. debt during Washington's 2011 battle over raising the debt ceiling. Moody's, the third agency, has its top Aaa rating for the U.S. under review.
Debt ratings are used by Wall Street to help set bond prices and interest rates. A credit downgrade by all three agencies could lead to higher borrowing costs for the U.S. over time.
"Fitch wants to see progress on a long-term deficit deal and wants to see it this year,'' said Anthony Valeri, investment strategist at LPL Financial. "This is probably another brick in the wall of a downgrade of the U.S.''
The across-the-board sequestration cuts, including $85 billion this year, were part of the 2011 law that raised the debt ceiling.
Fitch said the key driver of its U.S. credit rating is the future path of government deficits and debt. Based on its economic assumptions and current U.S. fiscal policy - including the sequester cuts - Fitch said federal debt held by the public will stabilize in 2014-2015 before climbing in the latter half of the decade to beyond 80% of U.S. gross domestic product.
Including the debt of states and local governments, general government debt is projected to reach 110% of GDP, Fitch said. Stabilizing federal and general government debt below those 80% and 110% levels is "a necessary but not sufficient condition" for keeping the AAA rating, Fitch said.
"In Fitch's opinion, further delay in reaching agreement on a credible medium-term deficit reduction plan would imply public debt reaching levels inconsistent with the U.S. retaining its 'AAA' status despite its exceptional credit strengths," Fitch said.
Fitch's report noted that a credible plan could include a mix of tax and spending measures, but it was up to elected U.S. representatives to decide on the specific elements and set the timeline for deficit reduction. However, Fitch said the USA's aging population means entitlement reform - reining in the costs of Medicare and Social Security - will be needed to contain spending.
The move comes as Democrats float ideas that would delay most near-term cuts, paying for some of the restored spending by closing tax loopholes that favor oil companies and millionaires. The AFL-CIO, the nation's largest union, called for the repeal of the sequester entirely. Republicans in the House have criticized the sequester, but have not proposed an alternative this year.
Economists and business groups have encouraged a package that swaps some short-term cuts for a deal that limits the growth of Social Security and Medicare, arguing that the retirement of the Baby Boom generation will make those programs grow unsustainably.
The fact that the deficit is shrinking in the near-term relieves some pressure for cuts, Valeri said. The Congressional Budget Office said Feb. 5 that the deficit will shrink to $430 billion by 2015, down from $1.1 trillion last year, before widening again later in the decade.