No Rest for the Wicked

With headwinds fading, the U.S. economic recovery appeared poised to pick up more substantially in 2013. Unfortunately, fiscal policy is going in the wrong direction.

Real GDP growth rose at a modest 0.1% annual rate in the 2ndestimate for 4Q12, but the economy was not as weak as that figure would seem to suggest. Inventories rose more slowly and defense spending fell, both subtracting significantly from GDP growth. Inventories and defense spending had risen in 3Q12, so some of the 4Q12 weakness was merely an unwinding of those third quarter effects. Taking the two quarters together, real GDP rose at a 1.6 annual rate in 2H12. Weak, but not horrible.

The soft second half GDP growth is at odds with the more robust pace of private-sector job growth (a +183,000 average monthly gain). Job growth has been the key driver of spending growth, as real wage gains have been trending about flat.

January’s two-percentage-point rise in the payroll tax has reduced disposable income and the rise in gasoline prices since the end of last year will reduce consumer purchasing power. These are short-term effects and are not expected to lead the economy into a recession. It will take some time for consumers to adjust to the payroll tax increase, as well as to higher gasoline prices, but spending growth should pick up in the second half of the year as long as job growth continues and gasoline stabilizes.

February vehicle sales results remained strong. Replacement needs should continue to drive sales over the next several quarters. That, in turn, helps industries that feed into auto production. Banks are more willing to make auto loans. However, one concern is that the weak global economy will likely retrain auto exports in the near term.

Despite a weak global economy, real GDP growth would likely have reached 3% or more this year. However, the increase in the payroll tax and the impact of spending cuts (the sequester) will likely cut that in half (1.5 percentage points from growth according to estimates by the Congressional Budget Office).

Business fixed investment was down in 3Q12, but stronger in 4Q12. Presumably, businesses were concerned about the fiscal cliff. However, it’s unclear why caution in capital expenditures would fade away in the final quarter. Fiscal cliff fears may have contributed to the slower pace of inventory accumulation in 4Q12, which should lead to gains in production in 1Q13. However, the slower rate of inventory growth may have been a response to an unusual increase in the third quarter.

In his monetary policy testimony to Congress, Chairman Bernanke reiterated the Fed’s focus on the job market. He outlined the potential costs and risks of the Fed’s aggressive policy actions (the forward guidance and the asset purchase program), but indicated that the benefits of QE outweigh the potential costs. A number of Fed critics wrote (over the last several years) that aggressive monetary policy would eventually lead to a substantial increase in inflation. However, inflation in the PCE Price index is trending well below the Fed’s 2% target. The Fed is still missing on both sides of its dual mandate. While the Fed is watching for signs that its actions may be fueling financial instability, asset purchases should continue until there is more substantial improvement in the labor market.

By reducing growth, the sequester may worsen the long-term budget outlook. Much of the drag could be reduced if leaders in Washington reach a broader deal on the budget. The current Continuing Resolution (which authorizes government spending) will expire on March 27. However, it’s unlikely that we’ll see any reduction in near-term fiscal tightening. Note that federal payments to the states are also part of the sequester, which means that state and local budget strains are likely to get worse – and we may see more government job losses.

© Raymond James

© Raymond James

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