The Other Sequestration That No One Is Talking About

From BofAML

The 2011 failure of the Super Committee produced a sequester that reduces budget authority in FY2013 by $85bn; resulting in estimated actual spending cuts of $42bn. What is less commonly known is that in FY2013 there is also a second sequester. The math behind the second sequester is even messier than the Super Committee sequester, but the bottom line is that it adds to the fiscal pain and highlights the complexity of the budgetary process.

You may ask yourself, how did we get here?

This second sequester results from a shift in budget authority from non-defense to defense for the current fiscal year. The shift in budget authority results from the passage of the FY2013 continuing resolution (CR), which provided funding for federal agencies through March 27. In aggregate, the current CR provides the right amount of budget authority ($1.047 trillion) for the year, as stipulated in the Budget Control Act (BCA) – i.e., the Super Committee sequester.

The problem with the CR is that it over-allocates budget authority to defense and under-allocates budget authority to non-defense by roughly $11bn. Once the current CR runs out, the extra $11bn in defense spending will be sequestered.

After the money’s gone

The second sequester has the potential to increase overall fiscal austerity this year. The exact magnitude of the additional spending cuts depends on the extent the Department of Defense (DoD) exceeds the BCA baseline. As a reminder, cutting budget authority does not necessarily translate into one-for-one spending cuts. At the very extreme, if the DoD has already used all $11bn of this additional budget authority, we will see an annualized hit of $19bn, or 0.1% of GDP. On the opposite end of the spectrum, if the Department of Defense did not use any of the extra $11bn, the second sequester would result in no additional austerity.

Putting an exact figure on the actual spending cuts resulting from the second sequester is very difficult. The Bipartisan Policy Center (BPC) finds that defense spending is currently running above its baseline pre-sequester budget cap. They estimate that the second sequester will result in additional austerity of $6bn in FY2013. On an annualized basis, that is a $10bn, or 0.06% of GDP, shock.

Letting the days go by

Unless additional legislation is enacted by March 1, the sequester will begin kicking in. As far as we are aware, there are no ongoing credible negotiations to replace or delay the sequester. As we explain in the Overview, we think it is very likely that the full sequester kicks in on March 1. We expect ominous headlines throughout March as the exact impact of the sequester is recognized. We believe this has the potential to increase market volatility.

Same as it ever was

In our view, the markets are underestimating the looming fiscal shock. The complex nature of federal budgetary accounting makes it difficult to quantify the exact size of the looming fiscal austerity. Including the additional austerity from the second sequester, we continue to expect total fiscal austerity this year of 2.0% to 2.5% of GDP.