The uncertainty related to U.S. fiscal policy was a hindrance to economic activity through the second half of 2012. "Worried consumers spend conservatively; worried businesses don't expand; worried investors are more risk averse," says Carl Tannenbaum, Northern Trust's chief economist. "None of these is especially helpful to market and economic performance."
Attention was acutely trained on Congress as last year drew to a close. The January 1 accord reached on personal tax rates kept the economy from falling off the fiscal cliff, but it left many issues unresolved. With automatic spending cuts set to become binding at the beginning of March, we're left with quite a bit of budgetary uncertainty as we move through the first quarter.
Some fiscal drag ahead
There was relief in many corners that potential tax increases were curtailed by the American Taxpayer Relief Act. Yet the expiration of the payroll tax holiday will still have an important effect on spending power. "The average household will be taking home about $1,000 less in 2013 as payroll taxes return to normal levels," Tannenbaum says.
Along with higher income tax rates for top earners (which will affect certain businesses, as well), this development is expected to limit consumer spending and constrain GDP growth.
Still to be determined are cuts in government spending that could also dampen economic activity. Current law calls for across-the-board reductions in defense and domestic programs to take hold on March 1. Negotiations surrounding the spending side are expected to be difficult ones.
Economic softness ahead
The tax changes that have been made, combined with potential alterations in spending, should cause the U.S. economy to grow more slowly during the first half of 2013. "After expanding at better than a 3% pace during the third quarter of 2012, we're expecting less than half that rate for the first quarter of 2013," notes Tannenbaum. "From there, though, we anticipate a gradual improvement as budget tensions recede."
In this scenario, we believe unemployment will decline very slowly, the Federal Reserve should continue with its stimulus programs, and interest rates would remain low.