Fiscal Cliff Crisis is Over But Debt-ceiling Crisis Looms
The fiscal cliff deal has put some important questions to rest. It has averted most—but not all—of the tax increases that otherwise would have kicked in at the beginning of 2013. The most significant tax hike comes from the loss of the payroll tax cut, which is valued at about 0.7 per cent of GDP. We estimate that the loss of the payroll tax cut will knock about 0.4 percentage point off the 2013 growth rate.
The other tax hikes are less immediately significant. The income tax increases at upper-income levels are worth only about 0.2 per cent of GDP in 2013, and their impact on spending will likely be limited, cushioned by a drop in the saving rate. Overall, our 2013 growth forecast has been reduced to 1.7 per cent, from 1.9 per cent, because of the expiry of the payroll tax cut (had the payroll tax cut been extended, we would probably have raised our growth forecast because of better momentum carried over from upward revisions to growth in the second half of 2012).
The debt ceiling is the next major flashpoint. The deal leaves major questions unanswered, though. It did not address the spending cuts threatened by the sequester, instead just postponing them by two months. Nor did it raise the debt ceiling, which will soon become a binding restraint on government spending, also in about two months. The debt-ceiling deadline is the one to worry about. Sequester-initiated spending cuts will kick in only gradually. In contrast, if the debt ceiling becomes binding there will have to be immediate, steep cuts in government spending, because the federal government will be able to spend only what it receives in revenues. Interest payments would probably be prioritized, but the ability of the United States to service its debt obligations would once again be called into question.
We have been here before, in 2011, but unfortunately appear destined to rerun that crisis again. And the arguments will not be just over spending. Although tax rates have been settled, that does not mean that revenues are now off the table. President Obama has made clear that he wants to replace the sequester with a combination of revenue increases and spending cuts.
We assume that a deal will be struck to replace the sequester and increase the debt ceiling, but only at the last minute—after another damaging episode of brinkmanship (bear in mind, hitting the debt ceiling would have far more severe consequences than going off the fiscal cliff would have done). We assume that the sequester will be replaced by tax increases (through limiting deductions, not through higher rates), and by spending cuts focused on entitlements, mainly medical spending, but also Social Security. We assume that the tax increases and spending cuts are roughly equal, and do not begin to kick in until 2014.
A Weak Fourth Quarter
Third-quarter GDP growth was revised up further to 3.1 per cent, from 2.7 per cent. Although this was a healthy revision, driven by final sales rather than inventories, it remains the case that third-quarter growth was driven by a combination of surging defense spending and faster inventory accumulation. Both of these factors went into reverse during the fourth quarter, dragging the growth rate down to an estimated 1.0 per cent. That’s soft, but better than the 0.5 per cent rate we projected a month ago.
We expect first-quarter growth to be no better than the fourth quarter, at 1.0 per cent, well below the 2.2 per cent pace that we projected last month. The primary reason is the expiry of the payroll tax cut, which has reduced our first-quarter consumer spending growth projection to 1.4 per cent, from 2.6 per cent.
The looming debt-ceiling crisis will also restrain growth.
Unemployment Key to First Rate Hike
As expected, the Fed is replacing “Operation Twist” with continued purchases of long-term Treasuries at the previous $45 billion per month pace. The big change in Fed policy is the commitment not to hike rates so long as the unemployment rate is above 6.5 per cent (conditional on inflation remaining well-behaved). Based on our unemployment projection, that implies no rate hike before late 2015.
By Nigel Gault
Nigel Gault is the Chief Economist with IHS Global Insight.