After a year that started with a fiscal cliff and ended with the first bipartisan budget deal in years, diminishing fiscal drag should give way to faster economic growth over the next two years, according to a new report by TD Economics.

“Despite the tax hikes in January, sequestration in March and a federal government shutdown in October, job growth was surprisingly robust over the last year,” said TD chief economist Craig Alexander. “With a budget deal that reduces the drag from sequestration over the next year, the underlying strength in the private sector should show up in faster economic growth over the next two years.”

From 1.8% in 2013, TD forecasts real GDP growth to accelerate to 2.7% in 2014 and 3.1% in 2015.

From shutdown to budget deal
Fortunately, out of the wreckage of the 16-day government shutdown emerged a budget deal that will avoid a similar fate for the next two years.

The deal also stems the impact of the dreaded “sequester” – forced reductions in spending that were themselves a consequence of past gridlock. The deal will likely reduce the level of spending cuts in 2014 and limit the drag to real GDP growth from 0.6%age points to 0.3%age points.

“Expiring tax provisions and reduced unemployment benefits will still act as a drag on 2014, but the bottom line is that it will be less than half of what it was in 2013,” noted Alexander.

Tapering is in the wings, but Fed is still two years away from raising rates

Less impact from fiscal policy gives the Federal Reserve room to move away from its non-traditional monetary policy efforts. The Federal Reserve surprised financial markets in September by passing on the opportunity to reduce its $85-billion bond buying program. Its reason for doing so was the potential for political gridlock and fiscal drag to further set back the economic recovery.

“We had the government shutdown in October, and yet key areas of the economy defied gravity. Employment and consumer spending growth actually accelerated during the affected months. For the Federal Reserve, all of the milestones for tapering have been met,” Alexander said. “The consideration now is how to taper without overly disrupting the momentum in economic growth.”

The complete findings of the TD Economics report are available online at