The Fiscal Cliff Comes Into Focus
By Zach Pandl
November 15, 2012
Investors and economists have been debating the fiscal cliff for more than a year. When budget negotiations fell apart in July 2011, the White House and congressional leaders delegated responsibility for finding additional federal savings to a bipartisan “super committee”. However, this group could not bridge the differences between the two parties either, and so the nation’s fiscal policy was set to the fallback option: automatically begin cutting spending and allow tax rates to set higher at the start of 2013. If Congress does not act, the fiscal cliff could severely crimp growth and undermine the recovery — all of which investors have known since last autumn.
Normally, markets tend to be forward-looking, and known events are fully reflected in asset prices long before they occur. But occasionally markets can seem surprisingly myopic, with the collective attention of investors abruptly turning to a new issue. The renewed focus on the fiscal cliff appears to be one of those occasions (the Fed’s QE programs are another example: markets focus closely on what the Fed might begin to buy, but less on when it might start to sell those same securities). The chart below shows the volume of Google searches for the term “fiscal cliff” over the last year. Although interest in the cliff had been steadily increasing over time, search volumes increased sharply at the time of the election. Apparently, the fiscal cliff appeared on some radar screens for the first time this week.
Although the fiscal cliff is now getting more attention, we do think that some type of budget tightening for 2013 was widely expected before last week. So how much fiscal restraint is already priced in? To answer that question, we surveyed a group of market economists and asked them a number of specific questions about their fiscal policy assumptions for next year. Although there was a dispersion of views, our survey showed a fairly clear consensus on a few points:
Amount of fiscal tightening: Most forecasters expect fiscal tightening of about $200 billion next year, or 1.3% of gross domestic product (GDP). This total reflects an expiration of the payroll tax cut, tax increases included in the Affordable Care Act, possibly an expiration of the Bush-era tax cuts for upper-income earners, as well as some spending cuts.
Impact on GDP growth: All the policy changes have different implications for growth, but the consensus appears to be for a drag of approximately 1 percentage point in total. The consensus currently expects GDP growth next year of around 2.25%. Therefore, excluding the impact of fiscal tightening, the consensus forecast for GDP growth would be roughly 3.25%.
The multiplier: Our survey showed that most forecasters were using a “multiplier” of about 0.75. That is, every $1.00 of budget tightening reduces GDP by $0.75. This number will be useful for sorting out the implications of any budget deal on growth expectations. It implies that every $50 billion in additional budget cuts (beyond the $200 billion already expected) should lower consensus GDP growth forecasts by about 0.2 percentage point.
To the extent that economists’ expectations are a good proxy for investors’ views, our survey suggests that asset prices should have already discounted a substantial fiscal drag next year. Although we will likely see budget restraint in 2013, this does not necessarily mean that interest rates need to fall further. Rather, what matters is the amount of fiscal tightening relative to what is already priced in. And we think that growth expectations already incorporate a good portion of the fiscal cliff.
The views expressed are as of 11/12/12, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
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