Wednesday, January 2, 2013

Musings on the "fiscal cliff", American politics and the near-term outlook for the US economy

Update:  Since posting the comment below, the US House of Representatives has also passed the American Taxpayer Relief Act.  House Republican attempts to attach spending cuts to the plan failed.  They know they will get to fight that battle over the next few weeks in the lead up to raising the debt ceiling.  An early 2013 outcome to go with our summary of 2012 as the year of the "crisis averted".

The US senate last night passed the American Taxpayer Relief Act to take the rough edges off the economic impact of the “fiscal cliff”.  The House of Representatives is still to vote, so it’s not a done deal yet. 

It seems we have spent much of the last two years waiting and hoping for politicians to do the blindingly obvious.  In the immediate aftermath of the GFC we mused that politicians would find it difficult to do what would be necessary to rein in large budget deficits.  That is certainly proving to be the case.

Markets were euphoric in the aftermath of the 2010 US mid-term elections when President Obama first lost the House of Representatives which delivered a divided congress.  The theory was it would curb the President’s regulatory inclinations.  What it did was weaken the decision making and legislative process.  Four more years...

After an arduous process, the deal extends the Bush-era tax cuts for individuals earning under $400k and couples under $450k, raise taxes on dividends and capital gains from 15% to 20%, and extends unemployment insurance for another twelve months (a not insignificant win for the President).  Payroll tax cuts expire as scheduled and will rise from 4.2% to 6.2%.

Tax was the area of greatest commonality as neither side wanted taxes to go up for everybody, so that where it was going to be easiest to get a deal done.  As we expected would be the case, the sequester of around $110 billion in expenditure was too complex an issue to deal with right now and will be left to the next session of Congress.  Legislators have given themselves another two months to work that bit out.

It’s certainly a relief that a deal appears close to being done it’s disappointing that it wasn’t a comprehensive package that dealt with all the components of the fiscal cliff.  They’ve had no shortage of time.  I am just a casual observer of American politics and its legislative process, but it seems to me that one side of the debate has become increasingly ideologically intransigent.  That makes timely pragmatic compromise a stretch target on every issue.

While the deal falls short of dealing with all aspects of the cliff, its light years away from the so-called "Grand Bargain" that was being contemplated just a few days ago.  At that point President Obama and House speaker John Boehner were boldly aspirational in talking of overhauls of the tax code and Medicare, as were possible wide-ranging changes to social security.   Right now progress on these complex longer term issues seems nigh on impossible.  That makes me worried about item 3 in my "Things to watch in 2013" post below.

This legislation doesn’t deal with the debt ceiling.  Treasury Secretary Tim Geithner earlier advised that the debt ceiling of $16.4 trillion was to be reached on December 31st 2012.  The Treasury is able to exercise what it calls “extraordinary measures” that will see them through until late February or early March before the ceiling needs to be formally raised.  That will coincide with negotiations on spending cuts.  So we get to do it all again soon folks.

As I mentioned before Christmas the good news is that at the bottom of a now reduced cliff is a gradually improving underlying economy.  In recent days we've seen good US housing market data and improved claims for unemployment benefits indicating the labour market held up relatively well as the fiscal cliff approached.  Only consumer confidence was disappointing, but that appeared directly related to fiscal cliff anxiety.  (An aside – we’ve also seen good PMI data out of China in the last couple of days supporting our view of modest recovery.)

Despite that better data, it still appears likely that December quarter economic growth will be the weakest of 2012.  I've got a 1.0% seasonally adjusted annual rate pencilled in, down from a recently upwardly-revised 3.1% in Q3.

The tax deal will stop the us economy plunging the full depth of the cliff, although the proposed tax increases will keep Q1 2013 growth similarly soft at around 1% (saar).  The expiry of the payroll tax cut will have the biggest impact on consumption as it affects everyone.  Tax increases for those on higher incomes will have some impact on consumption, but at those incomes level, I'm making the bold assumption they will have a bigger impact on the household savings rate.

Looking further out the housing market is improving and will become an increasingly important tailwind in 2013.  Also we know that firms have been delaying hiring and investment plans to some extent.  Hopefully they will soon feel confident to implement those plans.  We continue to see investment and exports as the key growth areas for the US.  We still see full year us growth coming in at around the "new normal" trend rate of 2% but for a change, and Congress willing, the risks appear evenly balanced.

Now back to the garden.....