Alternative Investment Management Association Representing the global hedge fund industry
A storm named Sandy brought the Northeast US to its knees in October 2012, and November saw the end of a long and bitter political campaign with President Obama’s election to a second and last term of office. Both of these events have exceptionally large implications for the US economy’s future. Taken together, Sandy and the election have provided a blueprint for reassessing the probability of various fiscal cliff scenarios, leading to the potential for improved prospects for real Gross Domestic Product growth in 2013 and beyond, even as the fourth quarter this year looks likely to show a decline.
Ramifications from Sandy
Going into the fourth quarter, before adjusting for Sandy, the US economy was probably on track for second-half 2012 real GDP growth near 2%. This 1.5% to 2.5% track has been more or less the same pace since the recovery began in the third quarter of 2009.
Due to the extensive damage Sandy caused in the mid-Atlantic and Northeastern corridor, with economic disruptions continuing well into November and impacting holiday spending as well, the negative effects of Sandy will dominate economic data releases for Q4 2012. Following a major natural disaster, we would typically expect to see higher new unemployment claims for several weeks, higher unemployment rates for a few months, and much more volatile monthly payroll employment data for four to six months. Because this storm covered such a wide area and did major damage to transportation networks and electrical grids, as well as destroying over a quarter-million vehicles, the disruption to data patterns will be unusually severe, making it extremely hard to detect the signal from the noise. Data releases in Q4 2012 and Q1 2013 are not likely to provide any insights into the longer-term state of the economy.
Doubtless, in the aftermath of Sandy, Q4 2012 real GDP will be depressed materially and a negative print for the quarter is likely. Considerable electrical power generation was halted from late October into mid-November and many businesses closed for extended periods, especially in the highly populated states of New Jersey, New York, and Connecticut. This will be reflected in declines in industrial production, retail sales, and other data for both October and November.
The impact of the storm on real GDP reverses in 2013. Storm clean-up and subsequent rebuilding efforts will bring increased economic activity, so that US real GDP data for the first half of 2013 may be positively impacted.
We note that GDP is a production and income concept that focuses on the flow of goods and services. The losses from Sandy, such as the destruction of housing stock, roads, and infrastructure, affected the valuation of the nation’s assets. Wealth was destroyed, but the rebuilding process will stimulate production and incomes.
Possible Scenarios for Resolving the Fiscal Cliff
While Sandy disrupted the short-run track of the US economy, first depressing and then augmenting it, the longer-term track remains highly dependent on the post-election political climate and the resolution of various policy issues associated with the fiscal cliff looming in 2013. The conclusion of the US election did not provide clarity on the likely timing and compromises that may occur, yet the election did change the incentive structure of some key players in the battle.
For starters, Obama is now a lame-duck President and he cannot run for that office again. With no campaign to run, second-term Presidents can focus on the longer-term, and no President wants a second-term recession to define his legacy. Winning the election may give the President increased confidence to bargain hard, but it also gives him a strong desire to avoid the fiscal cliff.
Moreover, 7 November kicked off the 2014 campaign for the House of Representatives and the all-important 2016 Presidential election campaign. Importantly, the Republicans are no longer running against President Obama. This one fact, by and of itself, represents a powerful incentive for House Republicans to avoid taking any chances that they might get blamed, rightly or wrongly, for sending the country off the fiscal cliff. Political incentives were all about defining differences – making compromise impossible. In the post-election period, both parties have strong incentives to bargain hard, yet to compromise in the end.
The political art of brinksmanship will be in full view with the timing on when to make substantive concessions and to close a deal. There is considerable pressure to cut a deal before the end of the year and avoid the expiration of the Bush-era tax cuts and the automatic spending cuts. Unfortunately, we would put the probability of a deal before the end of the year at less than half. Two serious problems impact the potential timing regarding the resolution of the fiscal cliff.
First, the task of developing a coherent long-term fiscal plan is immense, and the decisions truly difficult ones. Compromise is certainly possible, but one should not mistake newfound desire for compromise with the ability to agree to hard choices. In addition, the cost of rebuilding after Sandy will probably exceed $100 billion, with no apparent way to include these essential costs in an already squeezed federal budget.
Second, the year-end expiration of the Bush-era tax cuts, imposition of spending cuts, and other pieces of the fiscal cliff are not necessarily cataclysmic on day one of 2013. Consumers, investors, corporations… virtually everyone has gotten the email that the fiscal cliff is coming. One should not underestimate the caution taken in 2012 and the financial preparations that have been made already. Setting Sandy aside, we estimate that worries and precautions due to the looming fiscal cliff have already cost the US economy around 1.5% of real GDP and close to a potential million jobs that were not created in 2012, but could have been had a coherent long-term fiscal policy been in place.
The game of brinksmanship requires a catalyst with unavoidable consequences. The trigger for a fiscal deal may well be the breaching of the debt ceiling, somewhere in the first half of 2013. Tax and spending legislation can be postponed, or delayed, and will probably be made retro-active to January 1, 2013. The lesson of the summer of 2011 is that the debt ceiling is a hard line which cannot be crossed without immediate and severe consequences. As former Speaker of the House Newt Gingrich can attest, getting blamed for shutting down the federal government can be a ticket to defeat in the next Congressional elections.
Fiscal Cliff Resolution Scenarios
Political conflicts involving the fiscal cliff leave us with an extremely uncertain economic projection for 2013 and beyond. Essentially, if the worst-case fiscal cliff is avoided, 2014 and beyond look quite promising, assuming the Federal Reserve can manage its way out of its massive balance sheet without short-circuiting the expansion. This is a big assumption, so we will return to this topic after summarizing three fiscal cliff resolution scenarios.
Long-Term Austerity and Implications for Monetary Policy Risks
Unfortunately, even if the US Congress and President Obama resolve the fiscal cliff challenge positively, the economy’s problems are not over. Any long-term fiscal compromise will involve considerable fiscal austerity, even if spread over 10 years instead of concentrating half the pain in just one year. Thus, our optimism about economic growth if a fiscal compromise can be reached is based on removing uncertainty and rebuilding confidence in the future.
There should be no mistake, however, that the long-term growth path, given a possible decade of fiscal austerity and coupled with the aging demographic pattern of the country, is much more likely to produce 2.5% to 3% annual average real GDP growth than 3.5%-plus average growth. It is worth noting, that we would have argued for closer to a 2% to 2.5% long-term path if we were not projecting an “energy dividend” over the coming five years from the expanded natural-gas and crude oil supply in the US, but that is a separate story.
Given a long-run growth path that limits the country’s ability to outgrow its debt, the conduct of monetary policy will be extremely complex. That is, if the risks associated with the fiscal cliff are resolved, the focus will turn to the appropriate monetary policy to accompany fiscal austerity. Yet, the Fed’s future policy options have been vastly complicated by the balance sheet expansion of quantitative easing (QE) and the maturity extension program. A little historical context is useful.
In the last quarter of 2008 and in early 2009, the Fed expanded its balance sheet by roughly $1 trillion in what became known as QE1, or the first round of quantitative easing. There is little doubt that this action prevented a recession from turning into a depression, saving millions of jobs.
More controversial, however, are the long-term and potentially unintended consequences of the additional $1 trillion (and growing) of quantitative easing since 2010, known as QE2 and QE3, as well as the maturity extension program known as Operation Twist.
As argued in our research study published in September 2012 – “Quantifying QE” (www.cmegroup.com/market-insights/files/ed133-market-insights-quantifying-qe.pdf) – QE2, Operation Twist, and QE3 helped lower long-term Treasury bond yields by 50 basis points, distorted the yield curve, yet did nothing for creating jobs. Basically, we got no short-term economic lift while the long-term unintended consequences may be huge, as argued in William White’s working paper, “Ultra Easy Monetary Policy and the Law of Unintended Consequences” from the Federal Reserve Bank of Dallas (Globalization and Monetary Policy Institute, www.dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf, Working Paper No. 126).
Assuming that the US economy avoids the fiscal cliff and the unemployment rate declines in 2013 toward 7% (after a brief Sandy-induced return above 8% in Q4 2012), at some point, probably in 2014, the Fed is going to have to decide how to manage its exit from quantitative easing. A normal, yet still accommodative, monetary policy would probably have the Fed funds rate equal to or slightly above the measured core inflation rate.
That means when the Fed is managing its exit from QE, it will be incrementally raising the Fed funds rate from near zero to 3% or so. That is, a rising Fed funds rate may coincide with massive asset sales, which could put additional upward pressure on long-maturity Treasury yields. This will raise fears that the bond markets could be destabilized and the economic expansion derailed. Moreover, higher bond yields could require more fiscal austerity as federal government debt service costs rise above projections.
Once the economy is growing closer to its potential output, delays in returning to a normal monetary policy have huge inflation risks - potentially exacerbated by a weaker dollar - which are not apparent when the unemployment rate is as elevated as it is now. Chairman Bernanke states that these problems are manageable, and we do not doubt this.
We remain concerned, however, that the “manageable” solution will involve delays in returning to a normal policy and that the exit from QE may involve dollar weakness, rising inflation expectations, considerable Treasury market volatility, and the potential for elevated long-term yields that could slow an expanding economy.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.