Tomorrow's GDP report will be a major market catalyst as it will either confirm that an inflationary double dip has now arrived and the Fed will have no option but to print, or it will come "just better than expectations", once again sending the market into a lithium-deprived paroxysm of intraday jerkiness. Yet in the medium run, tomorrow's number is very much irrelevant, especially if Jan Hatzius' latest analysis on the impact of various trends at the local, state and federal level turns out to be correct. Goldman's analysis is based on the following assumptions: (1) Congress will not extend emergency unemployment benefits beyond the current expiration date in November 2010, (2) state governments will need to make do without any additional federal fiscal aid beyond what was included in ARRA, and (3) Congress extends the lower- and middle-income tax cuts of 2001-2003 as well as the Making Work Pay tax cut of 2009 but not the higher-income cuts of 2001-2003. The latter is of particular significance because as Bloomberg reports, Obama is about to take populism into high gear, as Geithner will next week bring the proposed tax cuts for the rich directly to the masses (and the corrupt simians in the Senate). Obviously the financial implications of that one move alone will be disastrous and even if tomorrow's GDP number prove better than expected, the market may ultimately trade off on the devastating impact from the expiration of the most important subset of tax cuts. Which is why, going back to Hatzius, the Goldman economist states: "The overall impact of fiscal policy (combining all levels of government) is likely to go from an average of +1.3 percentage points between early 2009 and early 2010 to -1.7 percentage points in 2011, a swing of about -3 percentage points. We estimate that the boost to the level of GDP starts to decline in mid-2010, first gently and then more forcefully, setting up a significant negative impact on GDP growth in late 2010 and 2011." The only thing Hatzius forgot to add is brace yourselves for impact. Yet somehow Goldman's own David Kostin projects that 2011 S&P EPS will grow by double digits... even as the firm's own economic team anticipates an economic crunch. This is precisely the conflicted double speak that we have grown to love and expect from the Wall Street sellside.
Full Goldman note below:
Today’s comment integrates state and local finances into our analysis of the impact of fiscal policy on real GDP growth. We include changes in spending and tax policy at the state and local level—as discussed in last Wednesday’s daily comment—directly in our analysis, instead of the transfer payments from the federal government to state governments in the American Recovery and Reinvestment Act of 2010 (ARRA). We believe that this results in a more complete and realistic assessment of the overall stance of fiscal policy at all levels of government.
These estimates imply that the overall impact of fiscal policy (combining all levels of government) is likely to go from an average of +1.3 percentage points between early 2009 and early 2010 to -1.7 percentage points in 2011, a swing of about -3 percentage points. The main difference compared with our federal-only estimates is a smaller positive impact of overall fiscal policy in 2009 as well as a somewhat earlier weakening in 2010. The reason is that state and local policies have exerted a drag on growth all along, and this drag has increased somewhat in early 2010.
Most analyses of the impact of fiscal policy on GDP growth—those of the Congressional Budget Office (CBO), the Council of Economic Advisers (CEA), and numerous private-sector forecasters including ourselves—have focused on the role of federal fiscal policy. More precisely, they have estimated the impact of the American Recovery and Reinvestment Act of 2009 (ARRA) on GDP relative to what would have happened to GDP in the absence of ARRA.
In general, these estimates are fairly close to one another. The CEA’s latest quarterly update summarizes three official and five private-sector estimates of the cumulative impact of ARRA on the level of GDP as of mid-2010, which are clustered in a reasonably tight range from 2.2% to 3.7%. (See Table 8 of the following report: http://www.whitehouse.gov/files/documents/cea_4th_arra_report.pdf; the preceding statement is based on the midpoint of the CBO’s “low” and “high” estimate.) Our own estimate of the impact is 2.6%, i.e. modestly below but fairly close to the midpoint of these estimates. Moreover, we estimate that the boost to the level of GDP starts to decline in mid-2010, first gently and then more forcefully, setting up a significant negative impact on GDP growth in late 2010 and 2011.
But while the impact of ARRA on GDP is an important question from both an economic and political perspective, it is not necessarily the best guide to the overall impact of fiscal policy on GDP growth, for at least three reasons.
First, there have been several “follow-on” fiscal programs since the enactment of ARRA, including the “cash for clunkers” program, the homebuyer tax credit, and repeated extensions of unemployment benefits. These need to be taken into account as well in gauging the impact of fiscal policy. (We have been doing this in our fiscal policy analysis already.)
Second, the potential expiration of the 2001-2003 tax cuts has received increasing attention in recent months (see Alec Phillips, “Extending the Expiring Tax Cuts: What, How, When, and Why,” US Daily, July 26, 2010). This also needs to be taken into account in a gauging the impact of fiscal policy. (We have been doing this as well.)
Third, although the analysis of the GDP boost from ARRA includes a line item for aid to state governments, this does not appropriately capture the impulse from state and local governments. In calendar 2009, ARRA provided about $60 billion of funding for state governments, which is equivalent to 0.4% of GDP. Including multiplier effects, this implies a boost to real GDP growth of around 0.5 percentage point in the standard ARRA-related calculation. But despite the ARRA funds, state and local governments have exerted a significant drag on real GDP growth since 2009, as we showed last week. (See “The State and Local Drag Continues,” US Daily, July 21, 2010.) This does not mean that the standard ARRA analysis is “wrong”—after all, if state governments hadn’t received funds from the federal government, they would have had to cut back even more. But if we are interested in the overall fiscal impulse to GDP, we should look at the impact of state and local governments on the rest of the economy via their spending and tax policies, not at the impact of the federal government on state government finances.
The chart below provides an integrated look at the GDP growth impact of fiscal policy at the federal, state, and local level. These numbers are based on our current assumptions that (1) Congress will not extend emergency unemployment benefits beyond the current expiration date in November 2010, (2) state governments will need to make do without any additional federal fiscal aid beyond what was included in ARRA, and (3) Congress extends the lower- and middle-income tax cuts of 2001-2003 as well as the Making Work Pay tax cut of 2009 but not the higher-income cuts of 2001-2003.
Two additional comments are in order. First, we have lengthened and smoothed out the impact of tax changes on spending in order to reduce the volatility in quarterly GDP impulses from fluctuations in tax refunds and final settlements from one quarter to the next. Second, we recognize that part of the impact from income replacement measures, most prominently emergency unemployment benefits, is not a completely “exogenous” consequence of a shift to more generous benefit provision in ARRA but also partly an “endogenous” consequence of weakness in the economy.
The upshot of the chart is that the overall fiscal impulse to GDP growth is likely to go from +1.3 percentage points between early 2009 and early 2010 to -1.7 percentage points in 2011. There are two main differences compared with our federal-only estimates—(1) a smaller positive impact in 2009 and (2) a somewhat earlier turn into negative territory in 2010. The reason for both is that state and local finances have been a drag on growth all along, and this drag has increased somewhat in early 2010. The earlier turn toward restraint may be one reason why growth has been weakening noticeably over the past few months, although the end of the positive inventory cycle has undoubtedly also been an important factor.
However, the basic implication is unchanged from our prior analysis—namely that fiscal policy will result in a substantial “swing” from stimulus to restraint. This is likely to contribute to slower GDP growth of around 1½% (annualized) in the second half of 2010, and it implies downside risks to our current forecast of 3% growth (on a Q4/Q4 basis) in 2011.