The past year has been punctuated by fiscal cliffs, tax hikes, sequestration, rising interest rates, a federal government shutdown and, to cap things off, a budget deal. Needless to say, fiscal policy has been a major drag on economic growth over the last year. Policymakers found a bridge over the fiscal cliff in January by extending income tax rates on 98% of tax filers, but, a 2.0 percentage point rise in the payroll tax and higher tax rates on high-income earners still cut over a percentage point from annual disposable personal income growth. The hit to personal income fed into weaker consumer spending and slower economic growth. Arbitrary government spending cuts made things worse. In March, sequestration came into full force, reducing federal outlays by more than $50 billion over the year. Altogether, tax hikes and federal spending cuts reduced real GDP growth by 1.3 percentage points over the course of 2013.
Still, the private sector continued to make progress. Home prices accelerated. The Case-Shiller price index rose at an annualized rate of nearly 12% over the first three quarters of the year, up from 6.5% in the same period in 2012. Alongside continued gains in equities, household wealth was up more than 11% over the first three quarters. So, while tax hikes restrained spending, healthier balance sheets provided a partial offset. This showed up most evidently in spending on durable goods. In November, light vehicle sales rose to 16.3 million (SAAR), the highest level since February 2007. Just as important, the economy continued to add jobs, which grew by an average 188,000 a month through to November.
So, what does all this mean for economic growth in 2014 and 2015? First, fiscal drag will diminish over the next two years. The recently passed bipartisan budget deal will reduce the drag from federal spending cuts from 0.6 percentage points to a little over 0.3 percentage points. Second, without another major tax increase, household income and improved confidence should prompt an acceleration in spending and maintain solid momentum in the housing market. Likewise, strength in broader sales growth will help propel business investment growth. Finally, with rebounding revenues, state and local governments can finally begin reinvesting after years of layoffs and spending cuts, offsetting the drag from the federal level. Altogether this should lead economic growth to accelerate from 1.8% in 2013 to 2.7% in 2014 and further to 3.1% in 2015.
From Shutdown to Budget Deal
Political gridlock reached an apex in October when an inability to find accord on a spending bill led to a 16-day government shutdown. The timing of the shutdown coincided with the need to raise the statutory debt limit. This threatened to wreak havoc on financial markets as well as sour consumer and business confidence. In the end, financial markets remained relatively sanguine, but consumer and business confidence did fall. In a twist, however, consumer spending growth accelerated in October, while businesses slowed investment.
All things considered, the shutdown had a relatively small effect on economic activity. The direct impact came from the furlough (temporary layoff) of government workers. Originally, close to one million workers would have been affected, but 350,000 defense workers were exempted and returned to the job shortly after the shutdown began. Congress also agreed to retroactively pay workers who were not on the job, which resulted in a short-lived impact. All told, the shutdown reduced real GDP growth by 0.2 percentage points in the fourth quarter. This will be made up entirely in the first quarter when government work hours are normalized.
On the bright side, out of the shutdown has come a new willingness to compromise. The recently passed bipartisan budget deal raises discretionary spending authority by $45 billion in 2014 and $19 billion in 2015. The increase is split evenly between defense and non-defense discretionary spending. As a result, the drag from federal spending will likely be reduced from 0.6 percentage points to slightly over 0.3 percentage points. Just as important, the budget will fund the government through the next two fiscal years. This will reduce uncertainty around government policy and should further support private investment.
State / Local Governments Start to Reinvest
While Capitol Hill developments capture the headlines, cutbacks by state and local governments have generally subtracted more from real GDP growth. Between 2010 and 2012, state and local governments subtracted an average of 0.3 percentage points from annual GDP growth and reduced overall employment by a cumulative 737,000. With interest rates at record lows and the private sector in the midst of deleveraging, these cuts could not have come at a worse time.
Fortunately, after years of expenditure restraint, revenue growth is finally outpacing expenditures, closing budget gaps and supporting reinvestment. We do not expect state and local governments to be the first, second or even third main source of economic growth over the next several years. However, there will be a meaningful 0.5 percentage point swing as the sector goes from offering a 0.3 percentage point drag to a 0.2 percentage point lift.
Advanced Economies Will Drive Global Growth
A consistent theme in the global economy in the aftermath of the Great Recession has been the relative strength of emerging market (EM) economies relative to advanced economies. As debt overhangs and aging populations combined to slow economic growth in advanced economies, a quick monetary and fiscal policy response in EMs allowed for a faster pickup in economic activity. Greater growth in emerging economies has benefited the United States, helping to shrink its trade and current accounts deficit. Alas, while the story has not ended, it is taking a bit of a detour. Over the next two years, the drivers of global growth are likely to return to advanced economies — especially the United States.
The shift in the composition of global growth is in part due to the reverberations of U.S. monetary policy. As the Federal Reserve contemplated tapering its asset purchases, investors headed for the exit on EM assets. This weakened their currencies, raised inflation and forced central banks to take defensive measures. Naturally, this led to slower growth for EM economies. At the same time, the biggest emerging economy — China — has begun to re-evaluate its growth strategy. After several years of supporting growth through investment, authorities have become concerned about the sustainability of its policies and have actively tried to slow credit growth and move the economy away from investment towards consumers. However, with investment representing close to half of Chinese GDP and consumer spending closer to a third, this process will necessitate a deceleration in economic growth.
In short, the rest of the world is counting on America to help them through this transition. Strengthening U.S. domestic demand implies higher imports, which are likely to be further supported by a stronger U.S. dollar — a side effect of the Federal Reserve easing asset purchases. As a result, net-exports will pose at least a modest drag on U.S. economic growth over the next two years.
Tapers and Acceleration
The main policy challenge over the next several years will be how the Federal Reserve unwinds its balance sheet policies without jeopardizing the much-needed acceleration in economic growth. The relatively steep rise in interest rates in 2013 is a cautionary tale to monetary policy makers that miscommunication can be costly.
Fortunately, the Fed’s task will be easier going forward. The markets have front-loaded much of the adjustment in longer-term yields in anticipation of tapering, implying less of a rise going forward. To help ground market expectations while easing asset purchases, the Fed will redouble its efforts in communicating its intentions to leave the federal funds rate on hold well into the future. By pushing out expectations for future short-term rate hikes, the Fed should be able to keep long-term rates from rising too quickly. Future rate increases will hinge less on tapering expectations and more on evidence of faster economic growth. As long as the Fed can maintain its credibility on short-term rates, even as economic growth accelerates, the rise in long-term yields should prove manageable.
At the risk of sounding like a broken record, we continue to see faster U.S. growth over the next two years. Substantial fiscal drag was a key reason for middling growth in prior years and particularly for 2013. This weight will lift on both the federal and state and local government fronts over the next two years. As fiscal policy ceases to be a drag on growth, the Federal Reserve will gain more room to move away from non-traditional monetary policy. Handling this transition will be tricky, but given the improvement in private-sector balance sheets and the considerable degree of pent up demand waiting to be unleashed, there is good reason to believe it will be achieved with stronger growth intact.
James Marple is a senior economist at TD Bank Group.