The tone of the press release to last week’s Federal Open Market Committee (FOMC) meeting may have been on the hawkish side of expectations, although the FOMC maintained its commitment to keeping interest low rates low until late-2014. Meanwhile, US economic growth was weaker-than-expected in Q1. This raises key questions about just how the Fed will behave for the remainder of 2012 and 2013.
Risky assets currently seem to be underpinned by decent corporate profit results for Q1. Does respectable corporate profitability imply no further need for monetary stimulus from the Fed? The 2001 recession was the result of a massive collapse in corporate profitability that triggered an implosion in capital spending. In response, the Fed did what was necessary to restore corporate profitability. Unlike 2001, the Great Recession was the result of excessive leverage and degrading asset quality in the financial and household sectors. The process of balance sheet adjustment has resulted in a sluggish economic recovery. The Fed has assisted in the adjustment process by helping to reduce household debt burdens, but the ultimate forces required are time and a recovery in labour demand. The Fed has a dual mandate, but the weights attached to price stability and maximum sustainable seem to be constantly shifting. The elevated level of unemployment would seemingly justify a higher weighting to the latter of the aforementioned mandates. This idea may now require re-examination: Fed Chairman Bernanke seems unwilling, at this point, to risk any unhinging of hitherto well-anchored inflationary expectations to drive unemployment lower via additional easing.
The Fed once again upwardly revised its growth outlook for 2012, although there was a modest downgrading of growth expectations for 2013.
The Fed has a dual mandate, but the weights attached to price stability and maximum sustainable seem to be constantly shifting. The elevated level of unemployment would seemingly justify a higher weighting to the latter of the aforementioned mandates. This idea may now require re-examination: Fed Chairman Bernanke seems unwilling, at this point, to risk any unhinging of hitherto well-anchored inflationary expectations to drive unemployment lower via additional easing. The costs to the Fed’s long-term anti-inflation credentials, in Chairman Bernanke’s view, would be too high to contemplate.
Growth Dynamics during Q1
The advance estimate for Q1 US real GDP was +2.2% (+2.1% year-over-year). This was below the expected gain of +2.5%. Real final sales rose a modest +1.6% in Q1 (+1.9% year-over-year), following +1.1% in Q4. The recent gains in final sales do not appear convincing enough on the surface to indicate that the economy will enter above-trend economic growth in either Q2 or H2. Strong gains in auto output contributed 1.1 percentage points to the +2.2% headline growth figure for the quarter. How sustainable is this dynamic? Furthermore, federal government spending deducted -0.50 percentage points from headline in Q1, but more aggressive fiscal drag is likely more forward based on current law, particularly in 2013.
Tighter Fiscal Policy Poses Serious Growth Risks in 2013
Based on current law, the US will experience unprecedented fiscal policy tightening in 2013. The expiration of the Bush tax cuts, elimination of emergency unemployment insurance and sequester cuts, reductions to defence and non-defence discretionary spending and higher taxes under the auspices of the Affordable Health Care Act (2010) are the main reasons for tighter fiscal policy.
The size of the tightening of fiscal policy is meaningful: the Congressional Budget Office (CBO) in January estimated that fiscal policy could be tightened by as much as 3.6% of potential GDP in fiscal year 2013, as based on current law. That figure could be higher, given that the CBO estimates were made before the extension of payroll tax cuts in February. Once these are included, the size of fiscal tightening reaches 4% of potential GDP in fiscal year 2013, which commences on 1 October.
If the fiscal tightening is measured on a calendar year basis, the figure rises to 5% of potential GDP. This is due to the fact that nearly all of the fiscal tightening starts on 1 January 2013 (nearly 3 months into the fiscal year). The impact of fiscal tightening of this order of magnitude would send the US recession into recession. Can history provide any useful lessons?
The last time fiscal tightening of this magnitude was imposed on the US was via the Revenue and Expenditure control Act (1968). The aim of the Act was to simultaneously curb inflation (the economy was overheating) and to fund the Vietnam War. According to the CBO, fiscal policy was tightened by 3.8% of GDP in 1969, helping to push the economy into recession. Meanwhile, the Fed lent a helping hand in producing a recession via tighter monetary policy.
Exciting Times Ahead?
Most politicians would agree on the need to avoid such a draconian tightening of fiscal policy, particularly when there is a real risk of the economy tipping back into recession. The political gridlock in Washington of recent years means that some form of fiscal tightening is inevitable next year. If fiscal tightening is limited to, say, 1.5% of GDP, then GDP growth could be reduced by 1 percentage point. This assumes a fairly conservative estimate for the multiplier.
The composition of any alteration to current law will ultimately determine the impact of fiscal tightening on the economy in 2013. It is widely believed that gridlock in Congress will prevail until after the election. This would leave the lame-duck Congressional session just a few weeks to reduce the size of fiscal tightening in 2013 via changes to current legislation, along with possible corporate tax reform. A daunting, but not impossible, challenge!
Fiscal Policy Uncertainty and the Fed
The uncertain outlook for fiscal policy and the prospect of meaningful tightening puts the Fed in a difficult situation. Faced with policy uncertainty, the private sector could become more cautious in 2012 H2, raising the pressure on the Fed to cushion the blow of fiscal tightening via further easing. With the policy rate close to zero, the Fed would seemingly be forced into further expansion of its balance sheet. The political constraints on further balance sheet expansion by the Fed should not, however, be underestimated.
