The last-minute deal over the fiscal cliff was just a prelude to further tough challenges in 2013 for the US and the Federal Reserve, says Guy Monson
WITH THE US government borrowing roughly 40 cents of every dollar it spends, it is no small wonder that the fiscal agenda continues to drive politics and markets.
While a long-term fiscal solution remains elusive, there has been some progress of late. On 2 January, President Obama signed a law that made permanent the Bush-era tax cuts on income, capital gains and dividends for all Americans bar those whose annual income exceeds $400,000. And although payroll tax cuts were rescinded, the new law removes the pervasive uncertainty surrounding the tax environment for households that until now has held back longer-term investment spending. So, all else aside, the law should provide a more stable tax backdrop for American consumers.
While some of the uncertainties surrounding the tax regime have been addressed, there are still significant challenges on the spending side. By the end of February, the US debt ceiling needs to be raised and $100 billion in automatic spending cuts are likely to go ahead if $1.2 trillion of budget savings over the next ten years are not identified.
Then, by the end of March, a new budget needs to be passed. This fiscal agenda would be a challenge for any legislative body, but the current constellation of uncompromising politicians, prone to brinksmanship and crisis-driven deal-brokering, makes it very difficult to envisage anything other than yet another last-minute solution addressing the fiscal challenge, and most likely only in part.
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But we should not be too transfixed by the constant ratcheting-up of political rhetoric. The brinksmanship leading up to the next fiscal deadline will most likely result in some sort of solution, partial or otherwise. When confronted with the reality of a default, both parties somehow find a workable way forward.
Meanwhile, the continued, generous support of its central bank will remain a prerequisite for recovery. In more ways than one, then, the December meeting of the Fed, in the run-up to the fiscal cliff, was a watershed event. Led by Ben Bernanke, the Federal Open Market Committee (FOMC) made two bold announcements. Monetary policy was not just to target current interest rates but was also to give heavy guidance on future rates. Moreover, this forward guidance was to be tied not only to inflation but also to employment thresholds.
NOW, WHILE THE Fed’s dual mandate of price stability and full employment has always set it apart from other central banks, this was the first time interest-rate policy was explicitly being attached to employment thresholds. Furthermore, the inflation threshold was set at 2.5 per cent — higher than the 2 per cent that many had believed to be the Fed’s long-run objective.
Confronted with a painfully slow economic recovery and persistent headwinds from deleveraging, the Fed has evidently decided to take the pragmatic decision to shed the inflation orthodoxy that has been central-banking dogma for much of the past two decades. Secondly, it announced that it was going to replace the expiring Operation Twist, committing itself instead to buy assets of $85 billion every month, or roughly $1 trillion over the next year. Such open-ended quantitative easing is a substantial commitment for a central bank, especially one with a $3 trillion balance sheet.
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Minutes of this meeting, published in the new year, suggest that the bold step was not an easy one; even as the Treasury purchase programme was initiated, there were differing views on how long it should be in place. Some members were uncomfortable with the balance-sheet risks, believing it more appropriate to end QE by the middle of 2013 and not in 2014 as anticipated by market participants. Understandably, the publication of these minutes has unsettled bond markets, with many fearing that a premature end to QE might unhinge support for bonds.
But while expectations of QE-infinity were possibly overdone, there are compelling reasons to believe that any exit from QE will need to be carefully orchestrated. Most importantly, a sudden, sharp backup in yields would jeopardise the recovery, forcing the Fed to backtrack its exit. This has happened before: in Q1 of 2010, emboldened by strong growth, the Fed started to map its exit from QE, but by the second quarter economic weakness had resumed and a second QE programme was initiated in November.
It was possibly in part these exit risks which forced the Fed to broaden its toolkit, embracing communication tools such as ‘forward guidance’ to anchor bond yields. But whatever the tools, the goals of the Federal Reserve are clear: allow real interest rates at negative to low levels to offset the forces of deleveraging and to aid the economic recovery, and, most importantly, avoid a premature exit which could prove self-defeating, particularly in testing fiscal and political times.
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