Tuesday, March 5, 2013

US sequester

Automatic spending cuts amounting to $85 billion kicked in on March 1st in the US, but that doesn’t change our view of around 2.0% GDP growth in 2013.

The spending cuts represent about 0.5% of GDP.  I had already factored in half that amount in my estimates of US fiscal drag this year, which is now just short of 2.0% in total. 

Tempering my concern about the extra cuts is the fact that a significant amount has already hit GDP growth.  Lower defence spending was a key contributor to lower than expect fourth quarter GDP growth last year.  (I must say it was nice to see the first revision of that result turn that small negative into a positive, keeping the story alive that the US has grown in every quarter since the GFC recession, despite numerous predictions of double dips.)

In fact the first quarter of 2013 is shaping up quite nicely GDP-wise.  The other fact that hit GDP growth late last year was the significant reduction in inventory investment in the face of fiscal uncertainty, particularly the looming tax increases.  With the worst of the tax increases avoided, inventory investment is picking up again.  That view is supported by latest ISM manufacturing data showing the new orders index at 57.8.  I think that result reflects post-cliff restocking rather than a more fundamental shift to a higher level of growth.  Weather volatility will also assist first quarter growth, which looks likely at this point to come in at around a 2.5% annual pace.

Underlying that relatively good quarter will be the fiscal drag effect of higher taxes on consumers which I expect will remain a constraining factor out to mid-year.  I put second quarter growth at around a 1.5% annual pace.

The back half of the year looks stronger as the tax increase impact fades and the emerging tailwinds of an improving housing market, stronger exports on the back of stronger global growth and the end of budget cuts at the State and local Government level all conspire to generate a modest acceleration in growth.  So despite the full force of the sequester coming to bear, I’m still comfortable with my forecast of annual average GDP growth of 2.0% in 2013 (2.3% q4/q4).

That level of growth will be sufficient to see continued modest gains in employment and a continued drift lower in the unemployment rate.  However, we don’t expect the Fed’s 6.5% unemployment rate “target” to be achieved any time soon, at least not this year.  Of course the unknown in that regard is the participation rate which I expect will head higher again as general economic conditions continue to improve.  A rising participation rate will limit declines in the unemployment rate. 

Assuming inflation expectations remain well-behaved, that should see quantitative easing continuing on into 2014, although the first step for the Fed will be a reduction in the quantum of monthly asset purchases which could come later this year.  Fed Chairman Ben Bernanke testified at Congress this last week and allayed fears of a premature end to QE.  While it’s entirely appropriate and healthy for the FOMC to debate the cost/benefit trade-off, Bernanke and his Vice-Chair (and possible successor) Janet Yellen both believe the benefits continue to outweigh the costs.