Will growing momentum be slowed by the sequester?
March 12, 2013
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To this point, markets have shrugged off the fiscal frustration coming from Washington. It seems as if economic activity is advancing nicely in spite of this headwind. Yet the across the board spending cuts (the sequester) implemented on March 1 will have an important impact on growth.
The next major fiscal deadline is March 27, as Congress must pass measures to fund federal government expenditures. Steps to avert a government shutdown have already been taken. Our forecast assumes that an updated spending resolution will be passed before the deadline, but that it will leave the sequester largely intact.
Recent economic data, for the most part, point to strong improvements on many fronts. But, the imminent reductions in government spending are likely to result in anemic economic momentum in the second quarter of 2013, followed by a measured rebound in the latter half of the year. In all, we estimate that budget reductions will curtail the rate of real GDP growth by about 0.5% during the balance of this year, all other things unchanged.
US Economic Outlook
Key elements of the current forecast:
- Taking into consideration the higher-than-expected increase in retail sales in February, an upward revision of the previous forecast of consumer spending is incorporated in the latest outlook for the economy. Tax refunds appear to have offset the projected impact of the expiration of the 2.0% payroll tax cut. Also, the $3.0 trillion increase in household wealth in the second half of 2012 is another factor supportive of the momentum in consumer spending. Higher gasoline prices could moderate consumer spending in March. The arithmetic disadvantage of slower growth in consumer spending in March could trim overall consumer spending in the second quarter, unless a tailwind in the form of strong employment growth provides support. For now, we prefer to err on the side of caution.
- Business inventory data for January also prompted us to rethink our estimate of inventories for the first quarter. The drought in 2012 and concern about the fiscal cliff accounted for the large drop in inventories during the final months of 2012. The January and February readings of the inventory index of the ISM factory survey shows a recovery after recording significant weakness in the fourth quarter.
- Putting together these new pieces information, real GDP in the first quarter is now predicted to have advanced at an annual rate of 2.8%. This forecast is tentative given that retail sales are subject to revision and we have only one months read on the notoriously volatile inventories component of GDP.
- Residential investment expenditures are projected to make a very strong contribution to real GDP this year. The low inventory of unsold homes, gains in employment, and favorable mortgage rates are factors supporting expectations of an increase in homebuilding. Construction of new homes and sales of new and existing homes, on a three-month moving average basis, are each at multi-year highs as of January 2013, albeit advancing from a historically low mark.
- The nature of incoming data (capital goods orders and Institute of Supply Management manufacturing survey), the low interest rate environment, and healthy balance sheets of businesses each support a constructive outlook for capital spending. Capital spending recovered in the fourth quarter of 2012 after posting a small decline in the third quarter. Overall, capital spending in 2013 is projected to outpace the 4.6% increase seen in 2012.
- The impact of the $85 billion cut in government spending in fiscal year 2013 will be become evident in actual data during the next two quarters. Budget discussions underway could alter the current trajectory of spending reductions, but we think the magnitude will not be altered much. This will produce a sharp decline in governments contribution to GDP.
- Exports fell at a 3.9% annual rate in the final months of 2012, a victim of soft economic conditions in Europe and Asia, with the former bearing the larger burden. The ECBs downward revision of projections of eurozone growth for 2013 bodes poorly for U.S. exports. Incoming industrial production numbers from China show a restrained pace of activity, implying a likely slowing of U.S. exports to China as well.
- The unemployment rate declined to 7.7% in February, after holding between 7.8% and 7.9% since September 2012. Payroll job creation has stepped up to a higher level, but estimates from the Congressional Budget Office suggest that the sequester will lead to the elimination of 750,000 jobs during the calendar year.
- For this reason, and because we expect the labor force participation rate to rise as hiring conditions improve, we predict only a modest decline in the jobless rate during the balance of 2013.
- The current mix of economic data final sales, unemployment rate, and inflation call for continued monetary policy support in the near term. Federal Reserve Vice Chair Janet Yellen remarked recently that a decline in unemployment, when it is not accompanied by sufficiently strong growth, may not indicate a substantial improvement in the labor market outlook.
- This suggests that short-term rates will remain anchored near zero. Long-term rates have backed quite a bit in recent weeks; while we do not think they will spring upward, it is entirely possible that we have seen the lows for this business cycle.