A slowly growing domestic economy is now exposed to the cruel blows of fiscal restraint. The resolution of the U.S. cliff will provide about $700 billion of fiscal drag in the next decade. With the payroll tax holiday expiring on Dec. 31, 2012, about $100 billion-$125 billion will be deducted from aggregate disposable income in 2013. Some states (notably California) instituted a large retroactive income tax increase (let's call it the
Phil Mickelson Tax
Finally, tax increases to finance the Affordable Care Act also went into effect on Jan. 1, 2013. All of these amounts to a fiscal drag of more than 2% of GDP spread over the next 12 to 18 months. Unfortunately, there is more drag ahead, reflecting the Budget Control Act of 2011, which dictates about $110 billion a year of sequestration over the next decade if Congress cannot agree on spending restraints.
Of course, there is a chance that addressing the budget will again be kicked down the road. In theory, policymakers could relieve the aforementioned fiscal drag by repealing or ignoring the Budget Control Act, but this would have other, unintended consequences to the fixed-income markets. As well, entitlement reform (which is long-term in nature) could be agreed to, eliminating the need for a sequester, but the growing animosity in Washington will likely preclude this from occurring.
There is also the chance that the private sector will recover rapidly enough to offset the fiscal drag. On that score I remain skeptical, as the recent regional PMIs indicate 2013 started with a manufacturing slowdown. Meanwhile, macro deleveraging is still incomplete. Moreover, the consumer, facing tax headwinds, appears spent-up, not pent-up. Check out
Women's Wear Daily
("a transtion year"), which suggests this morning's earnings release from the company could disappoint. And even the much-heralded housing recovery, despite its broad multiplier impact, seems too small a percentage of GDP (3%) to offset the other constrictive factors.
Expansive monetary policy, too, is likely no longer going to provide a tailwind to growth based on the recent distribution of the Fed minutes that the four-year asset purchase program could be coming to an end over the next 12 months.