Monday, March 26, 2012

America: keeping an eye on fiscal policy

With the recent run of more positive US economic data it could be tempting to start thinking about raising our GDP forecast for 2012. That would, in normal times, be a signal to start becoming more hawkish, or at least less dovish, on monetary policy. But these are not normal times.

Stronger job growth now appears to be leading to the virtuous cycle of stronger wage growth leading to higher spending which is in turn leading to more jobs. Also, the housing market appears to be forming a more solid base. These are both significant developments but we still don't expect either consumption or residential construction to become driving forces of US economic growth any time soon. That job remains strongly in the realm of exports and investment.

What stronger consumption and construction does is reduce some of the downside risk to the growth outlook. In particular, it makes us tentatively optimistic that we will not go through a third consecutive mid-year US double-dip scare. The risks to the US growth outlook are becoming more evenly balanced, but we are still happy with our forecast of 2% for 2012.

There is a monetary policy implication to the better run of data but it's of the "less dovish" variety: QE3 has become less likely. As you know we've never been great fans of the concept of a third round of quantitative easing (sterilized or not) on the basis that the problem of building a stronger more sustainable growth and jobs environment should not be laid solely at the feet of the Chairman of the Federal Reserve.

It's also the case that current labour market dynamics of zero productivity and rising unit labour costs do not support the case for more easing. However, we don't expect the Federal Reserve to change its forward guidance of an extended period of low interest rates anytime soon. That won't stop the bond market from testing that commitment from time-to-time, especially if activity data continues its good run.

The big unknown is fiscal policy. We know fiscal policy is going to be an economic headwind over the next few years, but we don’t know what the profile over time of the fiscal consolidation. Fiscal decisions made over the next few months will have a significant impact on growth and monetary settings in 2013.

There are a number of fiscal measures that are due to expire at the end of this year including the payroll tax cuts and the Bush tax cuts. According to the US Congressional Budget Office (CBO) if those measures are allowed to expire, the US fiscal deficit will shrink from 7.6% of GDP in 2012 to 3.8% in 2013.

That might sound like a good thing in a world worried about deficits and debt, but that degree of fiscal tightening represents a significant negative fiscal impulse and, if it were to play out, a likely return to recession. Recall when we first raised our concerns about QE3, we said the most likely scenario for it to be warranted would be if fiscal contraction was front-loaded and looked like pushing the US back into recession.

The “good” news is that degree of fiscal contraction is not likely to happen. The CBO's analysis of President Obama's 2013 Budget would see a deficit of 6.1% of GDP (note the 2012 starting point is different in each scenario). But there are the not insignificant issues of a President who does not control the House (although he has the Senate) and an upcoming election. It will be therefore difficult for the President to get his Budget measures through and there could be a new President in office in January.

The US growth environment is looking more robust. While that has implications for monetary policy, we need to get used to the fact that during this cycle, when the time comes for less stimulatory policy settings, monetary and fiscal policies will be working in the same direction. That will have implications for the amount of work monetary policy needs to do, and when it needs to start doing it.