Macro and Markets

Tuesday’s fiscal agreement defuses the fiscal cliff by deferring most tax hikes and pushing back the sequester.  A deal has been made, a financial crash avoided, and near-term growth prospects look rosier.  Markets have cheered news of the agreement. Is such cheer warranted? That depends on what happens next.  By itself, the package raises little revenue, creates new cliffs, leaves hard choices for the future, and by separating revenue and spending debates may make the next showdown over the debt limit more difficult to resolve.  If subsequent agreements make sustained progress towards addressing our long-term fiscal challenges, this deal may be seen as a significant first step; if not, it’s further evidence of dysfunctional government.  Either way, uncertainty around fiscal policy seems here to stay.  The next key dates are end February, when the debt ceiling becomes binding, and March 27th, when funding for the government expires. While the political debate has focused on the historic nature of the tax increases, at the core this is a deal to not raise taxes. Compared to 2012 policies, gross tax revenue totals $620 billion over 10 years and the deficit is reduced by $650 billion. While these are big numbers, they are small relative to the roughly $4 trillion in new deficits produced by the package compared to what would have happened if we went off the cliff.  Further, new revenue in 2013 amounts to only about 0.4 percent of GDP. That’s what happens when you make the Bush tax cuts permanent for 98 percent of the population. Details on the package are listed below. Next up is the debt ceiling, a cliff we had hoped could be avoided but was left unaddressed in this deal. Treasury has announced that the debt limit was reached at end-2012, and that exceptional measures will now be employed.  This is expected to allow the government to fund itself until around end-February.  If history is a guide, we face another down-to-the-wire negotiation with an immense amount at stake. Statements from both sides yesterday signaled profoundly different views of what a debt-limit deal would look like – Republicans wanting cuts in discretionary spending and entitlement reforms equal to the increase in the limit, while the White House made clear it will continue to demand a “balanced approach.” When both sides think they have the leverage, deals are hard to come by.  Further, with key tax elements now addressed, it may be harder to agree to the tradeoffs necessary to bridge these views.  It is also worth noting that the sequester, now that it has been deferred two months, will need to be dealt with at the same time. Assuming that deficit reduction in future agreements will be back loaded, the drag on the economy in 2013 from tighter fiscal policy looks to be on the order of 1% of GDP. Around half of this comes from the expiration of the payroll tax, with the remainder primarily reflecting tax increases for high income Americans in this package and taxes related to health care reform.  On this basis, the US should avoid a recession in 2013 though growth may well be below trend. Governing by deadline is a terrible way of doing business.  Leads to bad policy at home, weakens our status abroad.  This deal avoids hard choices and ensures continued policy uncertainty that will be a drag on the economy. It produces a small amount of revenue and makes permanent tax rates that are too low for the long term.  For all these negatives, give this deal a grade of incomplete.  On to the next cliff. The agreement Numbers are savings over 10 years based on newspaper reports and estimates from the Committee for a Responsible Federal Budget Income taxes (expected revenue $395bn). An increase to 39.6 percent for individuals making more than $400,000 a year and families making more than $450,000 (previously 35 percent). All income below the threshold will be taxed at previous (Bush era) rates. Dividends and capital gains ($55bn): The rate will increase to 20 percent for individuals making at least $400,000 and $450,000 for families. The rate will remain at 15% for everyone else.  (The Clinton-era rates were 20 percent for capital gains while dividends were taxed as ordinary income.) This does not include the previously passed 3.8 percent surcharge for those with income over $200,000/$250,000. Estate tax ($20bn).  The estate tax will rise to 40 percent for those at the $450,000/$400,000 threshold, and remain at 35% for others, with a $5 million exemption ($10 million per couple). The threshold will be indexed to inflation. Alternative minimum tax:  Permanently patched and indexed to inflation. Deduction caps ($150bn): The Personal Exemption Phase-out (PEP) will be reinstated with a starting threshold for those making $250,000. The “Pease” deduction will be reinstated for those making $300,000 or more. Extenders ($75bn cost relative to current law) .  Tax cuts first enacted in 2009, including the expanded earned income tax credit, child tax credit and college tax credit, will be extended for five years.  Other temporary business tax breaks will be extended for another year. Unemployment insurance (cost of $30bn). Extended Federal unemployment insurance continues for another year, benefiting those unemployed for longer than 26 weeks. Cost will not be offset. Doc fix.  Scheduled cuts to doctors under Medicare would be avoided for a year through medicare spending cuts that haven’t been specified. Sequester ($24bn).  The sequester will be delayed for two months and the cost of this move will be offset. Half will be offset by unspecified discretionary cuts, while half will be offset by a budget trick -- accounting for one-off revenue resulting from the voluntary transfer of traditional IRAs to Roth IRAs.   By deferring by only two months, it ensures the rest of the sequester will be tied into the debt limit debate. Other provisions.  A nine-month farm bill fix is attached to the deal, avoiding the "Milk Cliff." The bill also cancels pay raises for members of Congress.

One interesting footnote to the Fed’s decision today to introduce quantitative thresholds--that it expects to keep rates low at least as long as unemployment exceeds 6.5%, their inflation forecast doesn’t exceed 2.5%, and long term inflation expectations are well anchored--relates to the fiscal cliff. The fiscal cliff creates a risk to the outlook that is unusually sizeable in a short timeframe.  First, while some of the cliff is phased in over time (a “fiscal glide”), there are significant upfront effects that will be reinforced by potentially sharp moves in financial markets.  This suggests the pass-through to the real economy would be rapid.  Also, whatever the eventual outcome, uncertainty due to the fiscal cliff is highest over the next few weeks or months.  This is not a combination that monetary policy is well designed to address.  With interest rates at the lower bound, evidence that successive rounds of quantitative easing are having a diminishing impact on the economy, and the long lags through which monetary policy feeds through to the economy, the Fed has limited short-term ability to buffer the economy if we go off the cliff.  But there will still be a monetary policy offset through changing expectations of future policy.  If we go fully off the cliff, and growth plunges, the yield curve should flatten (bond prices rise) on revised expectations of easy-for-longer monetary policy and safe-haven flows, providing a brake against the worsening of financial conditions that would result.  Conversely, a good deal brings forward expectations of the timing of the recovery. What’s different now?  The new approach creates automatic adjustment by markets.  Now when a shock hits the economy, we change our forecast and reset expectations accordingly; we don’t need a confirming change in guidance from the Fed.  Chairman Bernanke emphasized this point in today’s press conference. Yesterday I blogged about the seeming disconnect between how NY and DC look at the fiscal cliff.  My bottom line was that while there was an upside to markets if a comprehensive deal was agreed that included the debt limit, the markets may be underestimating the risk of outcomes that leave the debt limit unaddressed and cause substantial uncertainty to persist into 2013.  This is still the case, but if the Fed’s new approach and the clarity it provides results in a stronger or quicker market response, then monetary policy may be a more effective buffer against a negative cliff shock.  In any event, it will be an early test of the new approach.