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The Cliff, the Fed, and the Economy

January 8th, 2013

by Scott Brown

of Raymond James

The budget deal removes a major uncertainty for the financial markets. We now know what tax rates will be. However, the American Taxpayer Relief Act (ATRA) has a number of drawbacks. The December 11-12 FOMC policy meeting minutes showed a split among Fed officials, but that doesn’t necessarily mean that asset purchases will end any sooner. The economic data reports have been mixed but generally indicate that the recovery is in reasonable shape.

The budget bill failed to prevent a two percentage point increase in the payroll tax paid by individuals (from 4.2% to 6.2%). For a household making $60,000 per year, this amounts to a $100 per month reduction in take-home pay. That’s going to hurt. Most workers have been unaware that payroll taxes were lowered for the last few years. However, they are going to miss the payroll tax cut when it’s gone. The increase in payroll taxes may shave about a full percentage point from 1Q13 GDP.

The budget bill did not address the federal debt ceiling, which was breached on December 31. Treasury can take evasive action (creative accounting) to fund the government for two or three months, but the debt ceiling will have to be raised. Well, maybe not. There are a couple of possible strategies to circumvent the debt ceiling. One is that the Treasury may have the power to issue a $1 trillion platinum coin, which it could then deposit at the Fed. Another possibility is that Treasury could invoke the 14thAmendment, which says “The validity of the public debt of the United States, authorized by law, including debts incurred for payments of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” Whether either of these moves would be legal is still in question. We’re likely to hear more in the weeks ahead.

The budget bill also did little to reduce the long-term budget shortfall. ATRA lowers the projected 10-year budget deficit by $600 billion. However, the full fiscal cliff would have lowered it by $4.5 trillion. In making tax changes permanent, ATRA will limit the ability of Congress to raise revenues. The bill passed the House without much Republican support. Many House Republicans are mad as hornets and will be looking for payback (that is, greater cuts in spending) in debt ceiling negotiations.

Still, while there may be some market anxiety in the next two months, the debt ceiling issues will be resolved one way or another. Moreover, having gone through the debt ceiling debacle in 2011 and the fiscal cliff follies in late 2012, investors are likely to have “crisis fatigue.” Been there, done that.

Part of the Fed’s decision to continue asset purchases in 2013 was likely based on concerns about the economic implications of the fiscal cliff. However, Fed officials had assumed that much of the fiscal tightening would be kicked down the road. The minutes of the December policy meeting showed that “several” FOMC members felt that the program might need to end sooner rather than later. Recall that the FOMC announced quantitative thresholds for the federal funds rate target at the December meeting. That is, the federal funds rate target will remain low for at least as long as the unemployment rate remains above 6.5%, the outlook for inflation one to two years out remains below 2.5%, and inflation expectations remain well anchored. In contrast, the threshold for asset purchases is qualitative. Purchases will continue until there is “substantial” improvement in the labor market. We’re not there yet. However, the one caveat is that some Fed officials fear that asset purchases will interfere with the normal functioning of the credit markets. The FOMC agreed to monitor financial markets closely, and if there is some evidence of that, then asset purchases could come to an end sooner. However, most likely, Fed asset purchases will continue throughout 2013.

The December Employment Report showed moderate growth in nonfarm payrolls. Annual benchmark revisions to the payroll data are due next month, but the Bureau of Labor Statistics has already indicated that the March 2012 level of payroll will be revised by about 450,000. The unemployment rate held steady at 7.8% in December and the employment/population ratio has trended roughly flat over the last year. That’s far from “substantial improvement.” The report showed a pickup in hours (although these figures are often revised) and higher hourly and weekly wages. Real income has been stagnant over the last several months, but a short-term increase could help offset some of the impact of the payroll tax increase.

The payroll tax increase and the upcoming mini-cliff are restraints, but economic growth is expected to pick up significantly in the second half of the year.

© Raymond James

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