Does A Republican Sweep Mean Further Expansion Of The Fed's Dovish Policy? Why Expiration Of Bush Tax Cuts Would Cripple GDP
Some interesting observations out of BofA's Jeffrey Rosenberg this morning, who plots the inverse correlation between the 2 Year yield and the Fed Fund futures implied time until the first Fed tightening. No surprise there, as the correlation is pretty much inverse, with the lower the 2 year yield goes, the further out into the future is the Fed's expected first tightening episode. Given the recent (expected and confirmed) collapse in the economy, this is no surprise. What is somewhat interesting, however, is plotting the increasing probability of a Republican control of the House versus the Fed's liquidity mopping expectations. Here, the two correlate almost one to one. This can be interpreted that the longer the economy deteriorates, the greater the revulsion toward the current political regime. Hopefully the consequence of this observation, that the Republicans will endorse a perpetual dovish stance on the Fed, is not true. Although at this point believing that the Fed will ever tighten again before there is a (violent) regime change seems quite naive. Lastly, some very bearish considerations by Rosenberg, who now estimates that the expiration of the Bush tax cuts will have an impact of 2% annualized reduction in household income worth about 1.3% of GDP, and that "such an increase if not reversed could trigger a double-dip recession." Setting aside the fact that we already are in the dreaded double D, the question of just how much worse the economic reality will get unless there is something done on the tax front, bears consideration by whatever is left of Obama's economic team.
First, here is BofA's observation on the 2 Year yield to Fed Fund correlation:
In only three months, expectations for the Fed have shifted from tightening to expansion of Quantitative Easing, reflecting deceleration in the economy and rising deflationary expectations. Correlated to this shift in monetary policy expectations, fiscal policy expectations are similarly shifting, as evidenced by increasing odds of a Republican house. Despite last week’s focus on the next move in monetary policy, fiscal policy shifts – and most notably the expiration of Bush tax cuts – likely hold as great an importance as changes in monetary policy. In the figures below, we highlight two measures of policy expectations.
In Figure 1, “Months to First tightening” is based on Fed Funds futures markets. This measure calculates when market participants first expect the Fed to begin tightening. As recently as June, the markets’ expectation for the first tightening
was November/December of 2010. Over the course of the last three months, that expectation has shifted out a full 12 months. That implies market expectations of the first Fed tightening move not until December of 2011.
Such an extension of expectations for the Fed correlates to the downshift in economic data. As well at the same time, interest rates in the US, reflecting the shift in Fed expectations from tightening to extended easing, went from a period of rising rates to a period of rapidly declining rates.
Yet the more interesting correlation is between the political implications of the mid-term election results and the Fed's actions:
We also can measure shifts in expectations for fiscal policy as well. Measures of political outcomes for the upcoming mid-term elections highlight recent shifts in probability most notablly of republican control of the House. Such measures include the Gallup Election 2010 key indicator that shfited in favor of “Vote for Republican” under the Generic Ballot for Congress on July 26th, the Cook political report measuring a “bottoms up” assessment of a net Republican gain between 35 and 45 seats where 39 seats puts the House into a Republican majority. Cook notes that “the odds of an outcome larger than that range greater than the odds of a lesser outcome.” That means that if the election turns out to be a “wave” election – where the outcome is determined more by national issues than local issues, the number of Republican gains would be greater than the 35 to 45 range, putting the House solidly into a Republican majority. Figure 2 highlights another measure of these shifts towards Republicans based on contracts traded on the Iowa Election Exchange where the most recent probability implied by these prices puts control of the House shifting to Republicans around 70%, up from around 40% at the beginning of June. As Figure 2 highlights, these shifts in expectations for the mid-term election correspond to the shifts in expectations for monetary policy. And both are in response to the weakness in the economic recovery.
And speaking of politics, arguably the most critical issue coming up for the economy, all the daily micro stimulus approaches aside, is the expiration of the Bush tax cuts. The economic impact of this will likely be far greater, and far more deleterious than anything accomplished to the upside in all of 2010 on the fiscal front by the administration.
As our economics team has highlighted, the policy implication of most pressing concern is the expiration of Bush tax cuts. They estimate an impact of 2% annualized reduction in household income worth about 1.3% of GDP, and that such an increase if not reversed could trigger a double-dip recession. The political shifts affect that outcome with one school of thought that a divided congress raises the odds of no legislation (and hence a default scenario of expiration). In the face of increasing evidence of a slowing economy, a compromise to avoid a fiscal tightening that could exacerbate the risks of a double dip likely rises, in our view. The question will be one of timing – can a compromise be reached ahead of the election (in our view, unlikely), in a lame duck session (again unlikely). In our view, that leaves a retroactive extension passed in January as the most likely compromise. But the damage to confidence in the intervening period may already be done under such a potential scenario. A further deceleration in the data may yet change that assessment, but in the intervening period, political uncertainty will not positively contribute to the economic outlook already diminished by a successive wave of negative data.