Some Encouraging News, but Further Uncertainties

Financial market participants welcomed signs that leaders in Washington were at least willing to talk to each other. However, it remains unclear what sort of agreement will be reached. A temporary extension of the debt ceiling sidesteps a near-term financial catastrophe, but does not remove uncertainty completely. The nomination of Janet Yellen to lead the Federal Reserve came as no surprise. Many investors see her as “a dove.” However, she has shown that she can be tough on inflation when required. Her main task will be to manage the transition to more normal policies. That’s a big challenge. Fortunately, she’s the right person for the job.

As many have noted, the current crisis over the budget and debt ceiling was not an accident. This was a strategy designed to repeal the Affordable Care Act. President Obama and the Senate Democrats were expected to cave, but that didn’t happen. Last week, amid falling poll numbers, Republican leaders abandoned their efforts repeal Obamacare. However, they seemed unsure of what they wanted instead. Negotiations in Washington typically end with both sides giving away something, so that each party can declare a partial victory and move on. What will it be now? There’s not enough time for a grand bargain on entitlement and tax reforms, but we could see some further reductions in spending into next year.

Some lawmakers frightened the financial markets last week by suggesting that it would be “no big deal” if the debt ceiling became binding. Obama could simply prioritize spending, pay interest and principle on government debt (preventing a default) and cut spending in other areas. However, there’s some question about whether this would be legal. Congress authorizes spending, not the White House. Who would not get paid? Social Security recipients? Private contractors? Even so, suppose it were legal. The economic consequences would be huge. The current budget deficit is about 4% of GDP. So, if the government were unable to borrow, you’d be talking about a 4% reduction in the economy right off the bat. Multiplier effects would likely turn that into an overall hit to GDP of 6% or more. In comparison, the Great Recession lopped 4.5% off of GDP.

Some are encouraging President Obama to ignore the debt ceiling. The issue is that the budget (which tells the president what to spend money on) and the debt ceiling (which tells the president how much he can borrow) are in conflict. Without an increase in the debt ceiling, the president would have to break one of these laws. If Obama were to ignore the debt ceiling, there would be a legal challenge, which could eventually be decided by the Supreme Court (which would probably rule against the debt ceiling). In the meantime, investors would face a period of uncertainty on how the situation would be resolved.

While the stock market rose on the initial discussions of a debt ceiling extension, there’s still a lot to be determined. A temporary extension would buy some time, but the possibility of a default would linger over the markets. Moreover, the government remains in a partial shutdown, which has likely already subtracted 0.3 to 0.4 percentage points from 3Q13 GDP growth. Add this to the 1.5 percentage points already subtracted from GDP growth this year due to the payroll tax increase and sequester cuts – you’re talking about the government taking away about half of the growth that might have occurred otherwise (that is, GDP growth this year would likely have been in the 3.5% to 4.0% range if not for tighter fiscal policy). The well-intentioned, but thoroughly misguided, focus on near-term deficit reduction has been a terrible mistake.

Janet Yellen will be responsible for the Fed’s transition to more normal policy. That’s expected to take years. In the meantime, she and other monetary policymakers will have to gauge the impact of what’s happening in Washington. The Fed has some ability to offset tighter fiscal policy, but it can’t counter all of it. That makes it more difficult for the Fed to begin reducing the pace of asset purchases.

Many market participants view Janet Yellen as “a dove” – that is, as being soft on inflation. However, as a Fed governor and former president of the San Francisco Fed, she voted 20 times to raise short-term interest rates and never dissented. She is a proponent of an “optimal control” approach to monetary policy. That means when faced with significant headwinds, the Fed should stick to a long-term optimal path even if policy is less than optimal at any particular point. In the current context, short-term interest rates would be kept exceptionally low for a longer period, even at the risk of inflation exceeding the Fed’s 2% target for a short period. This policy would still be consistent with a 2% target over the long term. Is that “dovish?” Not really. Moreover, this thinking is already in place at the Fed.

In public speeches and in her remarks on accepting Obama’s nomination, Yellen has emphasized the need for further improvement in the labor market: “the mandate of the Federal Reserve is to serve all of the American people, and too many Americans still can’t find a job and worry how they will pay their bills and provide for their families.” She noted that the Fed “ can ensure that inflation remains in check” and “can and must safeguard the financial system.”

As Fed Chair, Yellen will face the extraordinary task of normalizing monetary policy. She and others at the Fed are confident that the tools are in place to achieve that. She will also likely face a further near-term drag on the economy coming from Washington. We can wish her luck, but she won’t need it.

© Raymond James

© Raymond James

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