Budget battles threaten to undermine US recovery

The ‘forward guidance’ provided by the Federal Reserve led to expectations that tapering would automatically start in September, with many appearing to overlook the ongoing fiscal and budgetary problems that were evident earlier in the year.

The members of the Federal Reserve Open Market Committee, however, seemed more cautious in their September meeting. They noted the ongoing economic improvement but voted to hold the asset purchase programme steady until they can be convinced the “progress will be sustained”.

Willem Verhagen, senior economist ING Investment Management, points out the Federal Reserve chairman, Ben Bernanke, highlighted some of the factors influencing the delay to tapering and in particular cited the outcome of upcoming budget and debt ceiling negotiations.

“To some extent the introduction of QE3 one year ago may well have been a form of insurance against the fiscal cliff which was looming then. So it makes sense not to reduce this insurance when the downside risks surrounding the event it is supposed to cover are rising.”

The effects of budget brinkmanship in the Senate were witnessed in spring 2012, when the US lost its prized triple-A status amid political wrangling over the budget ceiling.

More recently, in March the failure of the two parties to come to an agreement over budget cuts led to the implementation of ‘sequestration’ - automatic cuts across most government departments. These, some argue, have contributed to the US recovery losing its lustre.

For example, Ian Kernohan, economist at Royal London Asset Management, suggests that economic growth has actually been weaker than was expected at the start of 2013 and has been held up by the spending cuts.

“Some sectors of the economy, such as housing, have been strong for much of the year, although other evidence suggests that growth in the middle part of the year has been curtailed by cuts in government spending (sequestration) and tax rises.

“Much of the recent fall in the unemployment rate has been accounted for by a drop in the percentage share of the population who are active in the labour market (the participation rate).”

Uncertainty ahead

So are we really once again facing a potential default for the world’s largest and most influential economy?

Dr Lucy O’Carroll, chief economist at Swip, suggests we not see a repeat of the internecine war we have seen previously, citing the improvement economic backdrop and the “narrower” array of issues to be resolved. She adds that the very fact the budget negotiation is a high impact risk most likely renders it low probability.

“The issues are narrower this time around and the short-term fiscal backdrop is more favourable. Two years ago, Congress and the Presidency were not only trying to negotiate on the debt ceiling but also on a $2bn-$4bn (£1.2bn-£2.5bn) deficit-reduction package, involving tax increases and cuts to fiscal transfers.

“In contrast, the government’s deficit has fallen this year to its lowest level since 2008 on the back of economic recovery.

“Congressional leaders are well aware that if they were to lead the country into its first ever sovereign default, voters could be unforgiving – particularly as payments the government might miss at the beginning of November include sensitive items such as social security and medical bills.”

Dr O’Carroll does, however, predict a period of “fraught negotiation” and identifies this as a key reason for recent “modest downward revisions” to forecasts for US growth this year.

“Assuming the situation is resolved, as remains most likely, the US economy should continue on its recovery path into 2014. However, this brinkmanship is no way to run fiscal policy in the world’s largest economy.”

In addition to the political impact on the economic recovery, further uncertainty surrounds the successor to Mr Bernanke, after the unofficial favourite Lawrence Summers pulled out of the race in September.

Mr Bernanke’s term of office ends on January 31 2014 and possible options for president Obama include trying to persuade the current chairman to stay an extra few years, choose a previous vice-chair of the Bank such as Donald Kohn, or the current vice-chair Janet Yellen.

Rick Rieder, chief investment officer of Fundamental Fixed Income at BlackRock, notes: “Investors may face more volatility amid the next few weeks of economic data, US budget showdown and debt-ceiling debate and the nomination of the new Fed chief.

“The significant divisions over monetary policy exhibited in the details of [the FOMC] decision mean the next Fed Chairman will have a huge and vitally important task in reconciling the views of policy makers and communicating them clearly to markets and investors.”

But he also points out: “Several other important changes to the membership of the FOMC coming up bear close scrutiny as we head into 2014, most notably the addition of noted policy hawks Richard Fisher of the Dallas Fed and Charles Plosser of Philadelphia as voting members while some of their more dovish colleagues rotate off.”

Outlook

While the US is clearly on the road to recovery, it is equally clear that there are still issues that could derail it. While this has led to many predicting more understated growth for the months ahead, the fact that most continue to predict growth at all against such headwinds says something about the view most have of the fundamental strength of the recovery.

Moreover, unlike some economies the issues facing the US are not outside of its own control. Its fate is in its own hands and can be easily controlled by the central bank and co-operation between politicians.

As David Daglio, portfolio manager and senior managing director at The Boston Company Asset Management, a BNY Mellon subsidiary, argues: “The US is entering a period of ‘self-recovery’ – where positive data prompts positive data – and we are encouraged by improved sentiment at the consumer, business and chief executive levels.”