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Monetary and Fiscal Policy in Early 2013
Raymond James
By Scott Brown
November 19, 2012

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The fiscal cliff refers to a substantial tightening of fiscal policy in 2013. Monetary policy cannot offset the cliff’s negative effect on the economy. However, it would be surprising if a deal were not reached, if not by the end of this year, then in early 2013. Due to concerns about the long-term budget picture, some of the cliff is almost certain to get through.

Alright, we’ve been over this and over this, and I’m going to keep going over this until I stop getting questions. Okay? There are two issues with the fiscal cliff. One is that the federal budget is on an unsustainable trajectory. No one disputes that or argues that we shouldn’t address it. There’s broad (not universal) agreement that everything should be on the table, tax increases, the possible elimination of deductions, entitlement reforms, and cuts to defense and other types of spending. That’s not what the fiscal cliff is about. The fiscal cliff refers to doing too much too soon to reduce the deficit and the negative impact that would have on the economy.

As any student of Econ 1 learns, raising taxes or cutting spending is contractionary fiscal policy – it dampens the pace of growth. That’s not to say that there may be cases where budget austerity has economic benefits. For example, deficit reduction under the first President Bush and Bill Clinton was viewed by some as helping to reduce long-term interest rates, which contributed to a capital spending boom in the late 1990s. However, we’re currently seeing no signs that government debt is crowding out private borrowing. Without any offset from the interest rate channel, contractionary policy is contractionary.

Some argue that we’re just lucky that China and other countries are willing to buy our debt. However, net foreign purchases of U.S. assets is a function of the trade deficit, not the budget deficit. If the U.S. runs a current account deficit (the current account is mostly the trade deficit), then by the laws of arithmetic and international trade accounting, it has to run a capital account surplus. We import and export a lot of goods and services. We import and export a lot of capital. We have a net trade deficit and a net capital surplus. End of story.

Okay, a quick show of hands here. How much did federal spending rise in FY12? 5%? 10%? 20%? Psyche! It was a trick question. Federal spending fell 1.7%. I know, I know. Hard to believe, right? It’s true. Spending in the last few years was boosted largely by the impact of the recession (unemployment insurance benefits, food stamps, the bank rescue, and the fiscal stimulus). With the economy recovering, spending has flattened out. In contrast, tax revenues sank sharply, and remember that a third of the $800 billion federal fiscal stimulus was tax cuts. Tax receipts have improved, but only moderately.

There’s a lot of pressure on lawmakers to reach a deal and they should have a compromise to avert most of the fiscal cliff. However, it’s unclear whether that will happen this year. The economy could withstand hitting the cliff, provided the White House and the new Congress move quickly to reach a deal in the new year. However, the uncertainty is already believed to have been a factor dampening business fixed investment. Hopefully, negotiations on the fiscal cliff will not collide with efforts to raise the debt ceiling, which is a completely separate issue.

Let’s assume that about a quarter of the fiscal cliff will go into effect next year and that the rest will be kicked down the road. That may shave about a full percentage point from GDP growth in 2013. The Fed cannot offset that impact.

The October FOMC minutes and Bernanke’s recent comments suggest that Fed policy will remain very accommodative in 2013. Recall that in its Large-Scale Asset Purchase program (QE3), the Fed is buying about $40 billion in Mortgage-Backed Securities per month (financed by money creation). In its Maturity Extension Program (“Operation Twist”), the Fed is buying $45 billion in long-term Treasury securities (financed by selling a similar amount of short-term Treasuries out of its portfolio). Operation Twist ends next month. There is wide speculation that the Fed will add Treasury purchases to QE3 in January.

Asset purchases are only one of the Fed’s extraordinary policy measures. The forward guidance, the conditional commitment to keep short-term interest rates low for a specified period of time (currently, through mid-2015), has played an important role in putting downward pressure on long-term interest rates. However, the Fed has been considering altering its guidance. Specifically, most Fed officials favor using economic variables in the forward guidance, either instead of or along with a calendar date. This would be something like “until the unemployment rate is x%.” However, the October FOMC minutes show that there was disagreement about whether this guidance should be quantitative or qualitative in nature. FOMC members agreed that they would have to work out a number of practical issues. Some believe that we’ll see a change in the framing of the forward guidance at the December 11-12 FOMC meeting, but it’s almost certainly too soon. However, the Fed is expected to announce its follow-up to Operation Twist in December.

Where does this leave investors? The uncertainty of the fiscal cliff is likely to hang over the markets and while a deal is possible by the end of the year (realistically, it would have to happen by the middle of December), it doesn’t seem likely – but we should see a compromise in early 2013. Interest rates are expected to remain exceptionally low throughout next year. Fed officials have signaled that policy tightening won’t begin in earnest until the job market shows considerably more strength.


(c) Raymond James


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