We are not sure about the exact schedule for avoiding the fiscal cliff. Few expect Congress and the president to agree on anything before the November 6 election. What happens during the six-week "lame-duck" session of Congress after the election will depend on the election's outcome. There is a good chance that there will be a repeat of the December 2010 deal, when the lame-duck Congress and the president agreed to a temporary extension of all tax cuts to keep the recovery going. Alternatively, there is also a chance nothing will get done until January, when the new Congress convenes and quickly delays the fiscal tightening that started January 1, thereby giving the new government some breathing room to negotiate a better fiscal package. We will see soon enough.
We believe one consequence of fiscal tightening is that the Fed will delay any tightening of monetary policy until the second half of 2014, or later. The economy can absorb only so much policy tightening in a short time period. Indeed, we think it likely that the Fed will continue its current policy of buying long-term Treasury securities.
Another consequence of the combination of fiscal tightening and monetary ease in 2013 is that Treasury bond yields should stay relatively low. A shrinking budget deficit, low inflation, and sluggish GDP growth-all of which we forecast-are commonly associated with low bond yields. That said, bond yields will also be influenced by how the financial crisis in Europe plays out.
Finally, in our view, the uncertainty about how the fiscal cliff situation will be eventually resolved has had, and will continue to have, a depressing impact on economic activity in the second half of 2012. Even if the fiscal cliff is averted with a last-minute political solution in late December, it will be too late; the damage caused by uncertainty would already have been done.
If fiscal tightening is a drag on the economy, then why do it at all? It needs to be done to prevent the U.S. public debt from swelling to unsustainably high levels, levels that would set off a financial crisis. In other words, for the U.S., the price of not correcting the fiscal imbalance would be turning into the next version of Greece. But the U.S. federal government, unlike Greece, is truly too big to fail. The world cannot afford to see US Treasurys turn into junk bonds in the decades ahead. These are precisely the concerns of the ratings agencies.
The Ratings Agencies
On August 5, 2011, Standard & Poor's (S&P) lowered its rating on U.S. sovereign long-term debt from AAA to AA+, and left the rating on negative outlook, indicating that another notch downgrade could come within two years. S&P justified the downgrade because of the continued failure of the political system to produce a fiscal consolidation sufficient to prevent ongoing excessive budget deficits. In S&P's view, the BCA that was passed in early August 2011 was not sufficient to stabilize the debt-to-GDP ratio.
Moody's and Fitch did not downgrade U.S. Treasurys, but both agencies have put Treasurys on a negative outlook warning. They, too, are concerned that the federal government has no plan for reducing its deficits to sustainable levels, but they have been more patient than S&P in giving the government time to work out a plan.
All three of the major ratings agencies have said they are waiting to see the results of the November elections and the kind of fiscal proposals the next administration and Congress will agree on, whoever wins. They have warned that failure to implement a plan to stabilize the national debt relative to GDP would be reason to downgrade Treasurys in the case of Moody's and Fitch, and to downgrade Treasurys again in the case of S&P.
The ratings agencies are not urging the U.S. to drive off the fiscal cliff. They are simply observing that a sovereign that wants a top rating must implement a sustainable fiscal policy. We believe that if the US adopts the degree of fiscal tightening in 2013 that we have in our baseline scenario, the country will probably avoid further rating downgrades in the near term.
The danger is that if, contrary to our assumptions, the U.S. avoids the fiscal cliff by extending all current fiscal policies but fails to implement a long-term plan for shrinking the budget deficit, all three major ratings agencies could downgrade Treasurys by the end of 2013.