The market appears convinced that it now has nothing to worry about when it comes to the fiscal cliff. After all, if all fails, Bernanke can just step in and fix it again. Oh wait, this is fiscal policy, and the impact of QE3 according to some is 0.75% of GDP. So to offset the 4% drop in GDP as a result of the Fiscal Cliff Bernanke would have to do over 5 more QEs just to kick the can that much longer. Turns out the market has quite a bit to worry about as Goldman's Jan Hatzius explains (and as we showed most recently here). To wit: "our worry about the size of the fiscal cliff has grown, as neither Democrats nor Republicans look inclined to budge on the issue of the expiring upper-income Bush tax cuts. This has increased the risk of at least a short-term hit from a temporary expiration of all of the fiscal cliff provisions, as well as a permanent expiration of the upper-income tax cuts and/or the availability of emergency unemployment benefits." This does not even touch on the just as sensitive topic of the debt ceiling, where if history is any precedent, Boehner will be expected to fold once more, only this time this is very much unlikely to happen. In other words, we are once again on the August 2011 precipice, where everything is priced in, and where politicians will do nothing until the market wakes them from their stupor by doing the only thing it knows how to do when it has to show who is in charge: plunge.
The Risks to Our View
- Despite the Fed's aggressive easing move at last month's meeting and the slightly better-than-expected economic data this week, the risks to our 1.5%-2% GDP growth forecast through mid-2013 are modestly on the downside.
- First, our "now-cast" for growth is a bit below the 2% pace that we had expected for the second half of 2012 a few months ago, as the data have been slightly disappointing even after the most recent upside surprises on jobless claims, the ISM, and auto sales.
- Second, our worry about the size of the fiscal cliff has grown, as neither Democrats nor Republicans look inclined to budge on the issue of the expiring upper-income Bush tax cuts. This has increased the risk of at least a short-term hit from a temporary expiration of all of the fiscal cliff provisions, as well as a permanent expiration of the upper-income tax cuts and/or the availability of emergency unemployment benefits.
- Third, the risks to the size of the "multiplier" that translates fiscal retrenchment into economic weakness are also on the more adverse side. Much recent economic research, including our own, has demonstrated that fiscal multipliers are large when the economy is operating at the effective lower bound for nominal short-term interest rates. We have generally erred on the side of caution in building such large multipliers into our actual forecasts, but believe that the case for making more aggressive formal assumptions is strengthening.
We expect a GDP growth boost of 0.3 to 0.75 percentage points from the Fed's "double punch" of open-ended quantitative easing and reinforced forward guidance. The lower end of that range is the estimated impact we would expect from the roughly 20 basis point (bp) easing in our Goldman Sachs Financial Conditions Index that has already occurred since a few weeks before the FOMC meeting, when the consensus was still for no move to QE in September. The upper end is the estimated impact into market expectations and financial conditions from a full front-loading of the $2 trillion (trn) in asset purchases that we ultimately expect under QE3.
All of these numbers are highly approximate, but the midpoint of the range is a bit higher than the 0.25-0.5 percentage points of growth boost from renewed QE that we had been building into our forecast during most of 2012. In addition, the economic indicators this week--the manufacturing and nonmanufacturing ISM as well as September auto sales--have surprised on the upside. Does this mean that we are on the cusp of an upgrade to our relatively cautious GDP growth forecast of just over 2% through the end of 2013?
The answer is no; in fact, we currently view the risks to our growth view as modestly on the downside, at least over the next 2-3 quarters:
1. A weaker now-cast. Our Q3 GDP tracking estimate has come down from a peak of 2.4% in August to 1.8% now, in response to weaker-than-expected data on personal consumption, durable goods shipments, and nonresidential construction spending. Our Current Activity Indicator (CAI) weakened sharply in August to just 0.5%, barely above the 0.4% reading at the peak of last summer's recession scare in August 2011. The very recent data on claims, the ISMs, and auto sales imply that September should look significantly better (perhaps 2%) but on balance our assessment is still that the economy's momentum has fallen slightly short of our expectation that growth would average 2% a few months ago. That affects the "jumping-off point" for any evaluation of the growth outlook over the next few quarters.
2. Higher risk of a worse fiscal outcome. As we have discussed recently, our worry about the fiscal cliff has increased in recent months as neither Democrats nor Republicans seem inclined to budge on the most contentious issue, namely the fate of the upper-income Bush tax cuts. While we have not changed our baseline assumption of an ultimate agreement to extend most of the major provisions--with the conspicuous exception of the payroll tax cut--the risk of at least a short-term hit from all of the fiscal cliff provisions as well as a permanent expiration of the upper-income tax cuts and/or the availability of emergency unemployment benefits has clearly grown.
3. Potentially larger fiscal multipliers. Related to the prior point, the risks to the potential consequences of fiscal restraint are also tilted to the higher side, even if Congress does extend most of the fiscal cliff provisions. Much recent economic research has demonstrated that fiscal multipliers are relatively large in a depressed economy that is operating at the effective lower bound for nominal short-term interest rates. For example, some studies have used cross-state variation in spending and taxes to isolate the impacts in a situation in which there is no monetary policy offset, and they have generally found rather large multipliers. Our own work using cross-country data and "shutting down" the monetary policy offset to fiscal contraction via statistical analysis has come to similar conclusions. We have generally erred on the side of caution in building such large multipliers into our actual forecasts, but believe that the case for doing so is strengthening.
The upshot is that we see a larger chance of downward than upward revisions to our forecast at this point. Any additional disappointments would presumably result in even more monetary easing than we have built into our baseline, so there would be some natural offset. That said, one lesson from the experience of the past few years is that the ability of monetary policymakers to provide support at the zero lower bound is relatively limited, barring a shift to even more aggressive measures than we have seen up to now