January/February 2013

TD Economics Forecast: Fiscal Austerity Will Slow Economic Growth in the Years Ahead

TD Economics said in its latest quarterly economic forecast that economic growth over the last year has been modest, but healing has continued as the housing market has become a tailwind rather than a headwind. The worst of the deleveraging cycle and its dampening effect on economic growth appears to be over, TD says, but, just as the U.S. economy appears set for take-off, one obstacle remains.

TD Economics announced that since this quarterly report was published, Congress has passed legislation avoiding the fiscal cliff. The bill extends income tax rates and puts off automatic spending cuts for two months but allows the payroll tax cut to expire. The deal was relatively close to the assumptions made in TD Economics’ forecast, but contains slightly less fiscal drag in the near term. The legislation has not caused TD Economics to materially change its forecast. What follows is TD’s report with amended content relating to the result of Congress’ new legislation.

Quarterly Economic Report

Since the last Quarterly Economic Forecast in September, some significant events have taken place — both expected and unexpected. In late October, Superstorm Sandy hit the U.S. East Coast, disrupting economic activity and causing billions of dollars of property damage. In November, the federal election left the power mix in Washington essentially unchanged; President Obama was re-elected, a Republican majority was returned to the House of Representatives and Democrats were left in control of the Senate.

Although the storm weakened economic growth in the final quarter of the year and the election eliminated one source of uncertainty from the outlook, these events have not changed the broad contours of our forecast. Economic growth over the last year has been modest, but healing has continued. The worst of the deleveraging cycle and its dampening effect on economic growth appears to be over. The housing market has become a tailwind to growth rather than a headwind. But, just as the U.S. economy appears set for take-off, one obstacle remains. After several years of record federal deficits, fiscal austerity will slow economic growth in the years ahead.

The economy expanded by a better than anticipated 2.7% (annualized) in the third quarter of 2012, but the sources of growth revealed a soft underbelly. Growth was lifted by an outsized rise in defense spending and accumulation of private inventories. Sales to consumers and businesses grew by just 1.3% in the quarter — its slowest pace of growth since 2009. Weak demand appears to have continued into the final months of the year. With government spending likely to resume its decline, the economy is on track to skim the bottom with only 0.6% growth in the final quarter of the year. For the year as a whole, the economy likely expanded by 2.2% in 2012.

Congress Avoids Fiscal Cliff, But Leaves a Number of Questions Unanswered

TD Economics reported that, on January 1, the U.S. House of Representatives joined the Senate in passing a bill that extends permanently income tax rates on 98% of American households and puts off $110 billion automatic spending cuts for another two months. The deal effectively avoids the fiscal cliff, but still leaves in place a fair degree of policy uncertainty.

The biggest single item in the bill is the permanent extension of income tax rates originally put in place in 2001 and 2003 for all income below $400,000. This takes off the table a potential economic drag of roughly 1.5 percentage points. For income above $400,000, tax rates rise to 39.6% from 35%. According to the Joint Committee on Taxation, this tax increase is expected to raise about $395 billion over the next ten years and about $35 billion in 2013, equivalent to about 0.2% of gross domestic product (GDP).

The bill extends for another year unemployment benefits for people unemployed longer than 26 weeks at a cost of about $30 billion. The bill does not extend the payroll tax holiday. Payroll taxes will immediately rise from 4.2% to 6.2%. This represents an average tax increase of $700 on all U.S. households.

There were a number of other numerous items, including an extension of tax breaks for low-income Americans including the Earned Income Tax Credit, and the Child Tax Credit, as well as for businesses through tax credits for R&D and a one year extension of 50% bonus depreciation — allowing businesses to write off 50% of the value of new investments.

Key Implications

As expected, America avoided the fiscal cliff with an eleventh-hour deal. The basic structure was close to what was anticipated. In particular, the single biggest drag on near-term economic growth was expected to come from the expiration of the payroll tax cut.

However, the legislation veered from TD’s expectations in one important area — the two-month deferral in spending cuts. This, among other measures such as a higher income tax hike threshold, means Congress passed a weaker version of legislation relative to our expectations. In turn, this means less economic drag in the near term.

TD Economics has revised up its real GDP growth forecast for the first half of the year from 2.1% to 2.3%. However, bear in mind that spending cuts remain on the front burner in Congress and will occur in some fashion after the two month grace period. Thus, modest upward revisions to the first half of 2013 will likely be met with modest downward revisions to the second half and potentially even 2014, once details on the spending cut measures are known.

For that reason, the 2013 real GDP forecast remains little changed at 2.5% (fourth quarter to fourth quarter), compared to 2.4% in TD’s December forecast. In other words, the basic story for the U.S. economy has not changed.

On the surface, a little more economic relief in the near term via less fiscal contraction seems like a positive development. But, the current legislation leaves considerable economic and policy uncertainty:

  • First, it lessens, but does not remove uncertainty related to fiscal consolidation. The lack of clarity on spending cuts could result in a persistence of underinvestment by firms, particularly those still caught in the spider web of negotiated political outcomes (i.e., industries in defense, healthcare, those dependent on procurement contracts).
  • Second, negotiations related to the deferral of the $110 billion in spending cuts will coincide with the debt ceiling limit when it is again maxed out, as the Treasury will have likely exhausted extraordinary measures by that time. This may turn into a déjà-vu of August 2011, when the lifting of the debt ceiling was used as the bargaining tool that ultimately created the fiscal cliff measures. Based on the 2011 experience, if these negotiations overlap and run down to the wire, it will likely inject another hefty dose of uncertainty into financial markets and restrain the economic recovery.
  • Third, until we know what measures will take place on spending cuts, the trajectory of the debt-to-GDP ratio will continue to worsen.

As Housing Market Rebounds, a Faster Recover is Waiting in the Wings

Business confidence has been deflated by fiscal uncertainty, but up until December, households appeared to be taking a brighter view of things. Consumer confidence, according to the Conference Board’s measure, rose to its highest level in November since early 2008. Consumers reported feeling better both about their present situation and their expectations of the future. Unfortunately, confidence took a step back in December as headlines turned to the unresolved fiscal cliff.

The recent decline in consumer confidence after several months of improvement, increased the urgency to resolve the fiscal impasse. The underlying positive trend in confidence over the past several months is reflective of the noticeable improvement in housing conditions. Home prices have risen consistently through 2012. Prices are up 5% from year-ago levels, according to the Core Logic Home Price Index.

The rebound in home prices appears to be the real deal and not a temporary blip. The reduction in construction over the last several years has removed the supply-demand imbalance. In many markets supply is tight. Looking at price growth across the country, the strongest performing states are those that were hit hardest by the housing collapse — the sand states of California, Arizona, Nevada and Florida. These states have experienced an increase in prices alongside a decrease in foreclosure inventories — a sign that the market is clearing.

The positive turn in home prices is important to the economic outlook for a number of reasons. First, it lowers the number of households that owe more on their mortgage than the value of their homes, thereby providing greater incentives towards mortgage payments and market stabilization.

Second, it reduces the downside risk to mortgage lenders as well as the losses faced on foreclosed properties. Over time, this should lead to a further improvement in mortgage credit availability. Third, it encourages homebuyers who are currently sitting on the sidelines to enter the market, helping to further cement the gains. Finally, it increases the incentive to build more homes. The rebound in construction provides a direct lift to economic growth and jobs.

A growing body of research suggests that a dysfunctional housing market is a major impediment to economic growth and is one of the main reasons that an economy suffering a significant recession does not bounce back quickly. There is little doubt that overhang of mortgage debt reduced consumer spending during the recession, but it also slowed the rebound by shutting many households out of credit markets altogether. This is why a recovery in both the housing market and consumer credit markets is a good reason to expect an acceleration in economic growth. As the vicious cycle in the housing market turns into a virtuous one, there is every reason to believe that a more familiar recovery will spring free.

Federal Reserve Will Do What It Can

An improving housing market is also central to the Federal Reserve’s strategy for supporting the economy. The Fed has pulled out all the stops over the last several months, engaging in another round of quantitative easing and taking the even more unorthodox step of making further asset purchases conditional on substantial improvement in labor market conditions rather than a firm deadline. The Fed has focused its attention on the mortgage market, purchasing $40 billion a month in mortgage backed securities. The purchases have helped reduce the spread of mortgage rates over ten-year treasuries and brought the level of rates to historic lows.

In December, the Fed made its conditional commitment to low interest rates even more explicit, announcing that the target for the fed funds rate would remain at exceptionally low levels “at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2% longer-run goal, and longer-term inflation expectations continue to be well anchored.”

The bottom line is that interest rates are likely to remain at very low levels for well into the foreseeable future. However, while the support to mortgage rates should help the housing market recovery, Fed members have repeatedly articulated that monetary policy cannot single-handedly offset the fiscal headwind.

Bottom Line

It has yet to materialize, but the American economy has taken the steps necessary to see growth lift off to a higher trajectory. After falling for the past five years, home prices rose consistently through 2012. Buoyed by this improvement, consumers are feeling increasingly confident about the future. The rebound in housing will support the recovery both directly, through an increase in construction, and indirectly, by underpinning consumer spending.

Looking beyond the immediate fiscal risks, the reality remains that fiscal austerity will weigh on economic growth for years to come. Next year will be a tug of war between stronger private demand and increased public sector restraint. The result is likely to be a pace of growth that is little changed from that over the past year. However, by the second half of the year, the tide should turn in favor of the private resurgence. By 2014, growth should accelerate further, reaching a level that allows for more meaningful job gains, reinforcing a virtuous cycle.