The fiscal clifflet: The forgotten fiscal threat
Aug 22nd 2012, 23:18 by G.I. | WASHINGTON
[Greg Ip] THE Congressional Budget Office kindly reminded us today of what has been manifestly obvious for months. If all the tax increases and spending cuts now scheduled for year-end are allowed to occur, the economy will tank. Today, in an update to the economic outlook, it said:
The deficit will shrink [by] almost $500 billion … Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013.
Actually, the recession would probably be worse. Given the inability of the Federal Reserve to meaningfully compensate, such a fiscal hit is liable to set off a self-reinforcing spiral of declining consumption and income, falling inflation and rising real interest rates.
However, the focus on the fiscal cliff is a bit of a distraction. The fact that it is such a large and predictable risk is why Congress is highly unlikely to let it happen (except perhaps for a few weeks, between December 31st and the inauguration of a new president later in January).
Here’s the real threat. Even if the Bush tax cuts are extended and the sequester delayed, a huge amount of fiscal drag remains in place. They include the expiration of the payroll tax cut, the expiration of extended unemployment insurance benefits, imposition of a new 3.8% Medicare investment tax on the wealthy, and the bite to discretionary spending embedded in the Budget Control Act and prior continuing resolutions. ISI Group projects $220 billion of fiscal tightening in 2013, or 1.4% of GDP. JPMorgan, noting that many Recovery Act programmes are rolling off at the same time, puts the hit at a slightly higher $266 billion, or 1.7% of GDP. The IMF reckons fiscal policy will tighten more in America next year than in Spain, Italy or Portugal. Though smaller than the full fiscal cliff, the fiscal clifflet still poses a significant headwind to the economy. If enough other bad stuff is going on, it could push the economy back into recession.
This is also weighing on the Federal Reserve. Minutes to the August 1st meeting released today disclosed that the Fed staff’s
near-term projection for real GDP growth was revised down somewhat…With the restraint from fiscal policy assumed to increase next year, the staff projected that increases in real GDP would not significantly exceed the growth rate of potential output in 2013.
This is an important reason the Fed is almost certain to ease monetary policy again when it meets Sept. 12. The key passage from the minutes:
Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.
The data have gotten a bit better since that meeting, but the improvement is hardly substantial, and fiscal drag militates against it being sustained. Expect the Fed to push out the period in which rates will remain near zero to past the end of 2014 and announce some sort of Treasury/MBS purchase programme. Don’t expect a radical reworking of its framework, such as a nominal GDP target.
Oddly enough, the clifflet is getting no attention in the political debate. Barack Obama’s JOBS Act contained a number of provisions that would have neutralized much of it for next year but it sank in the face of Republican opposition and the president seldom brings it up anymore. Mitt Romney’s stimulus plan, as far as I can tell, consists of the confidence-spurring effect of his plan to cut spending and taxes and shrink government. I suspect he will give traditional Keynesian stimulus more of a hearing once he’s in office. Still, the age of austerity has begun. Like it or not, it’s all up to the Fed now.
The original article is linked here.