The CBO baseline forecast is based on current law, meaning that its baseline assumes the federal government drives off the fiscal cliff. The grim view of the CBO is that real GDP would contract 1.3% annualized in the first half of 2013 but a recovery with growth of 2.3% annualized would begin in the second half of 2013. For 2013 as a whole, real GDP would rise a mere 0.5%. By contrast, if all current fiscal policies were extended so that there was no fiscal tightening in 2013, the CBO estimates that real GDP would rise 4.4%.
Sorry to say, I think the CBO baseline, grim as it is, is overly optimistic. The CBO forecast with no fiscal tightening strikes me as having projected real GDP growth over a percentage point higher than seems likely. That implies that if the economy goes over the fiscal cliff, the recession would be more severe than the CBO projects.
The stock market would be hit by a double-whammy. According to standard financial economics, the value of the stock market is the discounted value of future cash flows. The first whammy is that a recession would hurt the stock market by reducing future cash flows. The second whammy is that the discount rate for valuing future cash flows would rise because it depends on, among other things, on the tax rates on dividends and capital gains and depreciation allowances. This double-whammy likely would likely result in a significant correction to stock prices, with perceived safer dividend-oriented stocks exposed to this unhappy scenario just as non-dividend payors are exposed because of the worst-case change in taxation.
To cushion the blow of a substantial fiscal tightening, we believe the Fed would initiate a major "quantitative easing" (QE) program, which involves expanding the Fed balance sheet substantially via open market purchases of long-term Treasury securities and agency mortgage-backed securities (MBS).
The combination of substantial fiscal tightening and Fed QE would likely push down Treasury bond yields. I would not be surprised if the yield on the benchmark 10-year Treasury fell below 1.00%. That may seem extreme, but remember that the comparable yields in Japan and Switzerland are below 1.00%. On the other hand, another recession would likely drive up yields on higher-risk corporate bonds, as is typical in a recession.
2012 and 2014: Slowdowns Before and After the Recession
It gets even more complicated.
The impending fiscal cliff could cause some strange behavior in late 2012. Faced with a potentially much higher capital gains tax rate in 2013, higher-income households may engage in a wave of tax-related asset sales in late 2012 to take advantage of this year's lower tax rates. Something similar happened in late 1986, when households knew the capital gains tax rate was going to rise in 1987. Faced with a much higher dividend tax rate in 2013, businesses may pull forward some dividend payments and profit distributions into 2012. Businesses that typically compensate employees with bonuses may move up some payments from 2013 into 2012 so that the employees could pay a lower income tax on their bonuses. The result is that personal and taxable income might appear surprisingly high in late 2012.
Consumers may not experience the actual tax hikes until January, but to the extent that they are forward looking, anxieties about higher taxes could persuade many to start trimming their spending in late 2012. Insofar as consumer expenditures constitute about 70% of GDP, even a mild slowing in the pace of expenditures would weaken the economy. In other words, we might have a milder recession in the first half of 2013 at the expense of slower growth in the second half of 2012.
Knowing that depreciation allowances will be less generous in 2013, some businesses may pull forward investment from 2013 into 2012 to lower their taxes. The result would be somewhat higher business 8 investment in the second half of 2012 and somewhat lower investment in the first half of 2013. Something similar happened when the 100% deduction for qualified capital expenditures expired at the start of 2012: business capital spending was stronger in the second half of 2011 than in the first half of 2012 as businesses moved to take advantage of tax provisions about to expire.
Other businesses may delay investment and hiring. When considering major investment projects, business expansion, product rollouts, or new hiring programs, businesses must, at least implicitly, have a sense about the near-term business climate. If businesses worry about a recession, a slump in consumer spending, a hike in business taxes, or massive cutbacks in new government orders, they may find it prudent to postpone such activities until there is greater clarity about the direction of the economy. If all businesses become cautious at the same time, the result can be an economic slowdown. Sometimes uncertainty and anxiety about possible policy changes can matter just as much as actual policy changes. The two industries most at risk may be defense firms and utility companies.