Monday, August 27, 2012

U.S. Economy Contracts If Fiscal Tightening Occurs at End of Year (Fiscal Cliff Scenarios)

Portugal jan 08_0035
Sagres, Portugal (Source: Dysell)
By now you've probably heard that the U.S. economy will crash into a recession in 2013 if the "fiscal cliff" tightens policy at the end of the year (tax cuts and spending programs expire). Research reports released by the Congressional Budget Office (CBO) and International Monetary Fund (IMF) mentioned that fiscal tightening would negatively affect the U.S. economy (GDP), employment, and the stock market (only in the IMF report) in 2013. I provided their outlooks below.

On August 22, the CBO released an update to their 2012-2022 budget outlook which included post-fiscal cliff economic projections for 2013. The CBO projects that fiscal tightening will contract GDP by 0.5%, increase the unemployment rate to 9.1%, and lower the budget deficit to $641 billion in 2013 (from $1.128 trillion in 2012). They created an infographic that shows their baseline and alterative fiscal cliff scenarios (see below). And I also embedded the CBO's full chart slideshow of their budget outlook via slideshare.


What Is the Budget and Economic Outlook for 2013?

source: CBO (click img)
CBO’s Baseline: Taking into account the policy changes listed above and others contained in current law, under CBO’s baseline projections:

  • The deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4.0 percent of GDP), almost $500 billion less than the shortfall in 2012.
  • Such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013.
  • Because of the large amount of unused resources in the economy and other factors, the rate of inflation (as measured by the personal consumption expenditures, or PCE, price index) will remain low in 2013. In addition, interest rates on Treasury securities are expected to be very low next year."


Charts from CBO's August 2012 Budget and Economic Outlook from Congressional Budget Office



Now check out fiscal cliff scenarios from the IMF's '2012 Spillover Report' that was released on July 9, 2012. It's a good read on global sovereign debt contagion risk as well, involving China, the Euro Area, Japan, and UK. Since the G35 model's projections for U.S. output and stock market losses look the worst, here is their explanation on the model.

"The largest—not necessarily the most likely—hit to US growth comes from the G-35 model because it treats the cliff as temporary (i.e., private consumption does not rise to offset lower public demand), and since it builds in negative confidence effects (i.e., a 15 percent drop in stock prices, partially offset by lower long bond yields on account of the lower debt path)." 

Source: IMF

SoberLook.com posted charts from Credit Suisse and Goldman Sachs reports on fiscal cliff scenarios, and Business Insider posted JPMorgan's outlook and a recent outlook by Goldman's David Kostin. So it looks like there will be a recession next year and stocks will fall if there is no fiscal cliff deal. And don't forget the U.S. Treasury hits the debt ceiling again around the election. So can the Fed's printing press take on the next recession, falling EPS, and fiscal tightening? I really want to see the Fed attempt this.

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