The Future Of Fiscal And Monetary Policy Through The Lens Of Goldman Sachs

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Still confused by the last two days of Ben Bernanke testimony which in under 24 hours had elements of glaring contradiction? A) You are not alone and B) Judging by the market's response to the Congressional and Senatorial portions of Bernanke's testimony, not even he knows what monetary message he was trying to convey. And since all of his decisions are ultimately predicated by Goldman Sachs (either in the form of current GS employee Jan Hatzius, or former GS employee Bill Dudley) here is Goldman's take on the "Q&A on the Monetary and Fiscal Policy Outlook" based on Alec Phillips and Sven Jari Stehn's take of Humphrey Hawkins events in the past two days.

From Goldman Sachs

Following Chairman Bernanke’s Congressional testimony, the June 12 release of the June Federal Open Market Committee (FOMC) meeting and the ongoing discussions surrounding the fiscal outlook and the debt-limit, we devote today’s comment to discussing recent changes to the monetary and fiscal policy outlook in a Q&A format.

Q: Has the Fed’s assessment of the economic outlook changed?

A: Chairman Bernanke’s remarks on the outlook contained no meaningful surprises. He noted moderate growth in the recovery to date, held back by the household sector in particular, and said that the latest employment report attested to the weakness in the labor market. As in other recent remarks, he continued to point out that some factors holding back growth will likely prove temporary, and that the committee still expects acceleration in the second half.

The FOMC meeting minutes revealed some color on the risks to the outlook. These included further declines in housing activity and spillovers from Europe. Moreover, both Chairman Bernanke and the minutes noted concern about the potential failure to raise the debt ceiling "in a timely manner". Specifically, Bernanke painted a grim picture of the potential contraction in activity from a debt ceiling impasse—implying it could be of similar magnitude to the late-2008/early-2009 downturn. Also, he cautioned several times that Congress should avoid sharp budget cuts in the near-term that could damage an already fragile recovery.

Q: Have we moved closer to renewed monetary easing?

A: Chairman Bernanke delivered a balanced assessment of the policy outlook, saying that the economy could evolve in a way that would “warrant a move toward less-accommodative policy”, but that persistent weakness in activity and renewed deflationary risks would “imply a need for additional policy support”. Moreover, the prepared remarks included a list of potential easing options. These include (1) more explicit forward guidance on the funds rate and/or the size of the Fed's balance sheet, (2) a cut in the interest rate on excess reserves, (3) and additional security purchases or increases in the average maturity of the Fed’s holdings.

The balanced nature of Chairman Bernanke’s policy discussion suggests that Fed officials continue to see a high bar for either monetary tightening or easing. That said, we think that Bernanke’s remarks signal an upgrade of the seriousness of the easing discussion within the committee. Although Bernanke already listed these easing options in response to a question during the press conference on June 22, and the minutes to the June FOMC meeting likewise discussed the possibility of further easing in two places, we see their inclusion into the prepared remarks as a moderate dovish surprise. Although the likelihood of action remains low, we believe the probability of easing over the next six to nine months is now higher than the probability of tightening.

Q: What have we learned about the Fed’s exit strategy?

A: The minutes revealed that "all but one" FOMC participant agreed on the following exit strategy sequence. The first step would be to "cease reinvesting some or all payments of principal on the securities holdings in the SOMA." It is noteworthy that the minutes made no distinction between Treasury and agency securities here. Second, "at the same time or sometime thereafter, the Committee will modify its forward guidance on the path of the federal funds rate and will initiate temporary reserve-draining operations." Third, raise the funds rate target which "from that point on…will be the primary means of adjusting the stance of monetary policy." Finally, sales of agency securities "will likely commence sometime after" with intent to eliminate agency holdings over three to five years and normalize SOMA portfolio size over two to three years. This sequencing of the exit strategy is in line with previous speeches and comments on this topic, although it is unlikely to be of near-term relevance given the recent weakness in the economic data.

Q: How important is Moody’s decision today to put the US on review for possible downgrade?

A: The Moody’s move was well telegraphed and does not significantly increase the likelihood of a downgrade in our view. In early June, Moody’s announced that it would assess the state of discussions in “mid-July” and would place the rating on review unless “meaningful progress” had been made in negotiations to raise the limit. Moody’s statement today indicated that they viewed the probability of default as “low” but no longer “de minimis.” However, the move does not imply a downgrade unless a default actually occurs. As we have noted in the past (see for example “The Federal Debt Limit: More Risk to Spending than to Treasuries,” US Daily, May 18, 2011), we believe that the fundamental risk to Treasury interest and principal payments is low, in light of the ability to prioritize spending and the level of incoming revenues. Although we don't believe the Moody's announcement substantially raises the probability of a downgrade, it signals the possibility that the US rating will remain on negative outlook for some time. Specifically, Moody's states that in order to retain a stable outlook, the upcoming agreement should imply a "deficit trajectory that leads to stabilization and then decline in the ratios of federal government debt to GDP and debt to revenue beginning within the next few years."

Q: So has the outlook for reaching an agreement on the debt limit actually changed?

A: Not as much as the headlines would imply. It was only a week ago that the possibility of a $4 trillion “grand bargain” on deficit reduction dominated media reports. At that point, there seemed to be an expectation among many market participants that a deal was close at hand, with the possibility of a larger than expected deficit reduction package. A week later, the likelihood of a $4 trillion deficit reduction agreement looks low. However, the likelihood of reaching a smaller deficit reduction agreement coupled with a debt limit increase, or at least a temporary extension of the debt limit, has not changed nearly as much. There still appears to be agreement on well over $1 trillion in spending cuts, with spending cuts on the table in the Biden talks of potentially as much as $1.7 trillion. The debate continues to hinge on whether a deficit reduction agreement should include reductions in Medicare and Medicaid spending (which many Democrats oppose) and increases in tax revenues (which many Republicans oppose).

Q: What have we learned about the composition of a potential agreement?

A: Some new details have emerged, which support the view that near-term fiscal contraction would be modest. Yesterday House Majority Leader Cantor’s office released details of the various proposals that had been discussed during the fiscal talks led by Vice President Biden. In general, the items on the table conform fairly closely to our own expectations for the package, and confirm our view that near term fiscal tightening would be reasonably modest. We recently noted that the total spending reduction from a hypothetical $2.4 trillion deficit reduction package would reduce outlays in 2012 by only something like $50bn (or approximately 0.3% of GDP). Some of the policies differ from the hypothetical package we estimated but the broad strokes are similar and we would expect a similar overall fiscal effect. Although the extension of the payroll tax cut, which is scheduled to expire at year end 2011, was not mentioned in the outline released by Rep. Cantor, we do not see its omission as a strong signal and still expect it to be extended through next year, probably as part of a debt limit agreement.

Q: Is there a “Plan B” if Congress fails to reach an agreement by the deadline?

A: New plans are emerging, but there is not yet any agreement on a "Plan B" either. Senate Majority Leader McConnell (R-KY) has proposed increasing the debt limit by $2.4 trillion in increments. Under this plan, the president would be required to propose an equal amount of spending cuts to Congress to activate each increment of increase. Congress could then vote on a measure to disapprove of the increase. If passed, it would be expected to be vetoed by the president. Since it takes a two-thirds vote in both chambers to override a veto, the debt limit would effectively be increased under the proposal without an affirmative vote in Congress. The challenge for the proposal is that although the incremental debt limit increases would occur without separate legislation, Congress would still need to enact a law to establish the process in the first place. While some members of Congress might prefer a debt limit increase that implies unspecified spending cuts at some point in the future, there are many members of Congress, particularly in the House, who would prefer to enact binding spending cuts along with a debt limit increase.