During the lead up to the US presidential election, there were endless discussions on how each of the two candidates would handle the economic recovery. Now that the uncertainty of who will be leading the United States is gone, we have a clearer perspective on how the election’s results will impact two major questions: what will be the Fed’s monetary policy stance and will the U.S. enter a fiscal-cliff induced recession.
Impact on the Fed’s quantitative easing program and monetary policy
The Obama victory eliminates the small risk that Mitt Romney would have nominated a hawkish Fed Chairman in 2014. This in turn supports the policies of the current Fed and reinforces the FOMC’s “low for long” language regarding interest rates. In our view, the Fed made a historic shift to a more proactive stance at its September FOMC meeting, and this is likely to continue. Specifically, we expect the Fed to shift the conditionality of the current language from being date specific (i.e., mid 2015) to being dependent on the performance of employment and inflation. The challenge comes in agreeing on which of the particular indicators to monitor and where to set the thresholds that trigger action; thus, the committee is unlikely to come to a decision before early to mid-2013. A more immediate discussion will be whether the Fed will continue Treasury purchases after the expiration of “Operation Twist” in December. While employment data has picked up slightly in the US and other central banks such as the Bank of England are becoming dubious of the benefits of additional asset purchase programs, we expect the Fed to continue on the course it laid out in September. This most likely means the committee will vote to continue purchases of $45 billion in Treasuries with maturity greater than four years. As the Fed no longer holds shorter maturity Treasuries, we expect this policy will move to outright purchases rather than being accompanied with Treasury sales.
Impact on the U.S. fiscal cliff
We expect the fiscal cliff to subtract approximately -1.6% of GDP growth in the first half of 2013 as the payroll tax credit, Bush era tax cuts for incomes above $250,000, and some parts of the sequestration take hold. This expectation has not changed much as a result of the election because the composition of the Senate and Congress is the same and we had expected extreme political wrangling under either presidential candidate. It appears the best case is for the two political parties to come together with a very minimal plan to “kick the can” into 2013 by agreeing to small cuts of $50 to $100 billion in exchange for delaying the full sequestration cuts to defense and Medicare. This will leave the impact to 2013 GDP close to our expectations, while allowing for the possibility of a “grand bargain” which phases in future cuts more gradually and pragmatically. Housing activity and energy investment/employment should add moderately to GDP growth going forward, potentially 0.25% to 0.75% next year, but with GDP growth currently between 1.5% to 2%, the expected fiscal cuts will bring overall growth closer to 1% in the first half of the year.
While we are now certain of the election results and have a clearer view of the probable near-term impact, it remains to be seen whether elected officials will drive over the fiscal cliff, kick the can down the road, or work across the aisle and reach a more permanent solution. These unknowns, combined with what the Fed will do after Operation Twist ends and the effects of QE3, remain crucial unanswered questions.