The Fed and the Fiscal Cliff
By Zach Pandl
November 1, 2012
Prospects for this quarter’s results are being very closely scrutinized. After healthy growth in Q1, Q2 results proved quite sobering, as sales decelerated and operating leverage proved hard to come by. Given continued disappointing global macro growth, Q3 results seem tracking to be close to flat (down slightly) year over year again. Implicit in the consensus S&P500 estimate of around $103 is a reacceleration in Q4. Implicit in the 2013 consensus of around $115 is renewed healthy growth continuing consistently through the year. Such reacceleration seems highly at risk, which raises a few questions. First, why do we think 2013 estimates are too high? Second, does it matter or does the market already anticipate a more subdued earnings picture? Finally, what should investors do in the face of such uncertainty?
At its September meeting the Federal Reserve (Fed) made an important shift in its policy strategy. It decided to step-up its efforts to combat high unemployment, announcing a plan to purchase mortgage-backed securities (MBS) and a commitment to keep short-term interest rates low until mid-2015. We have termed these new tactics “high-beta monetary policy”, because Fed decisions will now be more sensitive to changes in the outlook for the labor market. Importantly, this means that the resolution of the fiscal cliff — which could greatly affect the labor market outlook — may have implications for rates.
The fiscal cliff is a series of tax increases and government spending cuts scheduled to occur at the beginning of 2013, together totaling about 4% of gross domestic product (GDP) (for more background on the fiscal cliff, see Columbia Management Election Perspectives, October 10, 2012). To some extent this fiscal tightening is already built in to economists’ forecasts and investor expectations. Our own surveys suggest that most forecasters expect a fiscal tightening of 1%-1.5% of GDP, and for this to slow GDP growth next year by about 1 percentage point (pp).
We do not know exactly what Fed officials expect for the fiscal cliff, but a reasonable assumption is that their estimates are not too far from private forecasters’ expectations. In his press conference after the last meeting, Fed Chairman Bernanke said about the cliff, “I suspect it won’t” occur — which we interpret to mean that he does not expect to see the full cliff effect. The minutes from the same meeting also noted that the Federal Reserve Board staff assumed in its forecasts that fiscal policy would be “tighter next year than this year”. Thus, the Fed seems to be in line with most observers: expecting some additional fiscal drag but assuming Congress will avoid going over the cliff entirely.
What if these assumptions are incorrect? To estimate the impact on rates from a fiscal policy “surprise” next year we simulated a small model of the U.S. economy. The model includes growth, inflation, as well as fiscal and monetary policy. We first constructed a baseline scenario which roughly matches current consensus expectations: a moderate fiscal drag, a slow decline in the unemployment rate, and a start to Fed rate hikes in mid-2015. We then simulated two alternative scenarios: (1) a worse outcome for the cliff, in which fiscal policy tightens by 2% of GDP more than expected in 2013; and (2) a better outcome for the cliff, in which fiscal policy tightens by 1% of GDP less than expected. We deliberately simulated asymmetric scenarios because we view the risks around the cliff as skewed toward a greater-than-expected fiscal tightening next year. The results are shown in the exhibit below. In the worse fiscal cliff scenario, the unemployment rate increases almost 1 percentage point (pp) relative to the baseline scenario and inflation falls modestly. This causes the Fed to push back the timing of its first rate hike to mid-2016 — about one year later than its current guidance. In contrast, in the better fiscal cliff scenario, the unemployment rate falls almost 0.5 pp relative to the baseline and inflation remains closer to the Fed’s target. In this simulation, the Fed brings forward its first rate hike to late-2014. The simulations suggest a rough rule of thumb: every 1% of GDP fiscal tightening relative to expectations should shift the timing of the first rate hike by about six months — with more fiscal tightening pushing out the first rate hike, and less fiscal tightening brining it in.
This hypothetical chart is for illustrative purposes only.
Both the better and worse scenarios are subject to a few caveats. In the better outcome, with less fiscal tightening next year, the implications for Fed policy would depend on how much fiscal tightening is assumed in the following years. If Congress simply shifts the cliff to 2014 the delay may have few implications for the Fed outlook. In the worse fiscal cliff outcome, the degree of uncertainty around the unemployment rate is unusually high. Despite tepid GDP growth over the last several years the unemployment rate has steadily declined, reflecting falling labor force participation. If labor force participation continues to drop, extra fiscal tightening may have more modest implications for the unemployment rate and for the Fed, even if it weighs heavily on GDP.
The views expressed are as of 10/29/12, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
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