Market focus shifts to the US fiscal cliff
September 30, 2012 3:18 pm
by Gavyn Davies
The looming fiscal cliff in the US has now replaced the actions of the Fed and the ECB as the major macro talking point in the financial markets. Although most investors expect that the American political system will find a way out of the large fiscal tightening which is currently scheduled to take place in 2013, there is a great deal of uncertainty about how and when this will be accomplished. In the meantime, concerns about the fiscal cliff have now clearly started to damage capital goods orders in the business sector, which last week dropped in a manner which is normally seen only in recessions.
The US economy remains fragile, and a large downward shock to capital spending, which now seems inevitable in the final quarter of the year, is certainly not what the doctor ordered. It may well lead to a further slowdown in GDP growth in Q4, from the already anaemic 1.8-2.0 per cent rate which seems likely for Q3. However, unless policy makers in Washington prove unable to break free of political gridlock after the elections on 6 November, it still seems improbable that the economy will slide into recession early next year.
Under present legislation, US fiscal policy is scheduled to tighten by around 4-5 percentage points of GDP in 2013 as the Bush tax cuts are allowed to expire, government spending is cut, payroll taxes increase and unemployment support declines. This unusual combination of contractionary fiscal events has arisen from the compromises which were needed to raise the debt ceiling last year, when Congressional leaders were unable to agree to long term reforms on the “Bernanke” model. Such reforms would eliminate immediate fiscal tightening, but would legislate to ensure fiscal sustainability in the long run.
Instead, Congress decided to “kick the can down the road”, leaving open the worrying possibility that the exact reverse of the Bernanke recommendation would take effect — ie immediate fiscal tightening with no long term reform.
The election odds built into the betting markets at present are summarised in the accompanying table, devised by Vincent Reinhart of Morgan Stanley.
After a shift towards the Democrats in recent weeks, the betting market now suggests that the most likely outcome of the elections (with a 50 per cent probability) is a return of the status quo, with an Obama Presidency, a Democratic Senate and a Republican House. That, and other forms of gridlock, are shown to be 62 per cent probable. A sweep for the Republicans is 15 per cent likely, but Reinhart argues that this, too, would involve a substantial fiscal tightening as government spending is cut back. A Democratic sweep, which is judged 19 per cent likely, is the only scenario in which an early fiscal tightening could be easily ruled out. [1]
The size of the fiscal tightening which could take place next year if no agreement is reached to change existing legislation is of course far too large to be offset by monetary easing. Calculations by Sven Jari Stehn at Goldman Sachs show that the combined effect of QE3 and the communications strategy announced by the FOMC in September will be to ease the GS financial conditions indicator by only 0.20-0.50 per cent, which might boost real GDP growth by 0.30-0.75 per cent in a year’s time. If true, this would offset only a small part of the damage which would be done to growth if the fiscal cliff took effect. A deep recession would become inevitable, simply from the adverse impact of the budgetary tightening on aggregate demand.
Furthermore, the fiscal cliff would probably damage the supply side of the economy as well as the demand side, since it would involve increases in marginal tax rates across the economy. Political and economic opinion in the US is, of course, sharply divided about which of these effects is likely to be the larger, but as William White wrote recently, “we do not live in an either-or world”. Why not get rid of them both? (David Malpass reminds us that this was in effect the Reaganite strategy, though he does not concede that it caused a rise of around 4 per cent of GDP in the budget deficit as well as markedly higher GDP growth. Such a large rise in the budget deficit would not be tenable today.)
In any event, US business is now showing concrete signs of worrying about fiscal uncertainty by postponing or cancelling plans for capital expenditure. The durable goods orders data for August, published last week, were somewhat alarming. Core capital goods orders over the latest three month period have been falling at an annual rate of -18 per cent, which is usually an indicator of impending recession:
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Capital goods orders are often very volatile on a monthly basis, but the recent decline seems much greater than normal fluctuations might explain. Capital goods shipments are likely to plummet in Q4, taking the investment component of GDP down with them. According to David Hensley at J.P. Morgan, who has done the arithmetic, the decline in orders will lead to a fall of in shipments at a 6 per cent pace in Q4, and this will knock about 0.6 per cent off the growth rate of real GDP.
So are we observing the first signs of a retrenchment in business spending which will end in recession? Fortunately, we are not seeing any indication of that in the labour market. Up to now, US businesses seem to have restricted their actions to delaying (or cancelling, we do not know yet which it is) capital expenditure, while continuing to expand their labour force at a moderate pace:
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Initial unemployment claims, which are a reliable early warning indicator of major inflexion points in the labour market, have been gradually improving in recent weeks, and consumer sentiment about the state of the labour market, contained in the consumer confidence surveys, has also improved.
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Up to now, the sharp drop in capital goods orders has been an outlier in the economic data, though a very worrying outlier. Provided that there is no outbreak of mass insanity in Washington in December, a US recession still seems like a low probability event.
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Footnote
[1] Note that the probabilities do not sum to 100 per cent because of imperfections in the political betting markets.
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