The Fiscal Follies, the Economy, and the Fed

The deal reached last week does not remove uncertainty about the budget and debt ceiling. We could go through a similar crisis in three months. The hope is that lawmakers will learn from the recent experience and work together. The fear is that the two sides may grow further apart ahead of another round of sequester cuts set for January 15. In mid-September, Fed Chairman Bernanke cited uncertainty about negotiations in Washington as one factor in the decision to delay the initial tapering of asset purchases. Many stock market participants therefore believe that the continued fiscal policy uncertainty will prevent a tapering this year. That’s not necessarily the case. Fed policy will remain data-dependent.

The “Continuing Appropriations Act, 2014” funds the government to January 15. Congress will then need to pass another bill to authorize spending. If not, we could see another partial government shutdown. Negotiations are likely to be difficult due to the further round of sequester cuts set for January 15. Recall that the debt ceiling crisis ended with the creation of a bipartisan supercommittee that was tasked to come up with a long-term plan to reduce the federal budget deficit. Failing that, sequester cuts to spending would kick in (beginning in January 2013, eventually delayed to March). The sequester would hit discretionary spending across the board. The idea was that these cuts would be so onerous to both parties (defense is more than half of discretionary spending) that the two sides would be forced to work together. However, the Supercommittee was doomed to fail from the beginning. So here we are. Both parties detest the sequester cuts. Yet, the two sides have been unable to come together to do anything about them. Now, we’re set for more pain in mid-January. Last week’s deal calls for bipartisan House-Senate negotiations on a long-term budget outlook by December 13. It seems highly unlikely that the two sides will find common ground by then.

The deal did not raise the debt ceiling. It suspended it until February 7, at which time the new debt ceiling will be whatever the federal debt is. Beyond February 7, Treasury can take extraordinary measure (such as using certain government retirement funds) to continue borrowing for at least a few weeks and possibly, if it can make it to April 15 (when tax revenues pour in), for several months. The deal also included the so-called McConnell Rule, under which Congress (both chambers) can pass a disapproval on raising the debt ceiling. The president would then veto that bill, which could be overridden by a two-thirds majority vote in both houses. Some lawmakers have pushed for an adoption of the McConnell Rule as a long-term fix for the debt ceiling. The deal last week makes that rule only temporary. It expires on February 7.

The government shutdown has had a negative impact on economic growth. Furloughed federal workers will receive back pay, but the disruption to wage income will have had some effect on consumer spending. Private contractors (for example, food service providers at the Smithsonian museums) who lost business during the shutdown will not be paid. There are also indirect effects. Businesses in general may have delayed hiring and capital expenditures due to the uncertainty. With worries about the budget and debt ceiling likely to linger, there may be a further slight drag on growth through the fourth quarter.

Minutes of the September 17-18 Federal Open Market Committee meeting showed that many officials were concerned about the impact of the tightening in financial conditions, “as well as about the considerable risks surrounding fiscal policy.” In his post-meeting press briefing, Chairman Bernanke noted that “the extent of the effects of restrictive fiscal policies remain unclear, and upcoming fiscal debates may involve additional risks to financial markets and to the broader economy.” While last week’s deal may have prevented a financial market catastrophe, it did not reduce uncertainty completely. Sequester cuts arriving in mid-January are expected to dampen 2014 GDP growth by a few tenths of a percentage point. Monetary policy, under current conditions, has been unable to offset fiscal drag on GDP growth this year.

The continued uncertainty surrounding the budget and debt ceiling should complicate the Fed’s decision on when to begin reducing the rate of asset purchases. Following last week’s deal, financial market participants seem to have concluded that the ongoing uncertainties in Washington will prevent the Fed from beginning the taper this year. Yields on long-term Treasuries fell. TheNew York Fedsurveyed the primary bond dealers before and after the September policy meeting. At least three-quarters of those surveyed expected some reduction in the rate of asset purchases at that meeting. After the FOMC meeting, most expected an initial tapering at the December 17-18 policy meeting. The odds on a December tapering have likely fallen.

Without a doubt, the key factor in the Fed’s December decision to taper will be the economic data, especially the labor market figures. Unfortunately, the partial government shutdown will distort a number of economic data releases. This week, the Bureau of Labor Market Statistics will release the delayed Employment Report for September, which may be subject to seasonal distortions (related to the beginning of the school year). Looking ahead, nonfarm payrolls should take a hit in the October report (now due November 8), but will likely rebound in the November report (due December 6). Stronger-than-expected data could prompt action, but all else equal, noisy economic data will make the Fed less likely to taper.

© Raymond James

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