Tax cuts, government spending and highly accommodative monetary policy provided a potent cocktail of stimuli in 2003, boosting the economy and financial markets. It's unlikely that government policy will be in such full force in 2004, but that doesn't mean the stimulus bonanza is about to come to an end.
Like a parent helping a child learn to ride a bicycle without training wheels, the government will try to hang on and provide support for as long as possible before letting the economy ride solo.
"My feeling has always been this stimulus is about inflating our way out of a huge debt morass vs. real concern about deflation," said Bernie Schaeffer, chairman of Schaeffer's Investment Research in Cincinnati. "In that sense, as long as spigots can possibly be kept going, they will be."
Thanks, in part, to a heavy dose of stimuli, the past year was a blockbuster one for equities. The
is up 43.6% on the year (as of Dec. 12), on track for its third-best annual percentage gain since its debut in 1971. The Russell 2000 is up more than 40%, while the
Dow Jones Industrial Average
are each up about 20%.
Of course, those heady gains followed devastating down years in 2000, 2001 and 2002. On some level, major indices may have enjoyed a solid 2003, if only for reflexive reasons. But it's fair to say actions by multiple arms of the federal government helped ensure that occurrence, or certainly helped facilitate larger-than-expected gains.
"Part of the reason
the economy performed so well in the third quarter is that there's more stimulus in the pipeline today than there has been since World War II,"
Governor Mark Olson said last month. "That stimulus is in part tax cut, in part tax rebates, in part deficit spending and a significant part an accommodative monetary policy."
The Bush administration's tax-cut rebates helped fuel consumer spending, while lower rates on both long-term capital gains and dividend taxes emboldened equity investors. Due largely to the tax cut plus higher spending on homeland defense and the war on terror, the federal budget deficit rose to $400 billion in fiscal 2003 from $158 billion in fiscal 2002, according to the Congressional Budget Office. Most economists agree the huge increase in deficit spending helped the economy recover from recession, a recovery punctuated by the robust 8.2% GDP growth in the third quarter.
In addition, the Bush administration's lack of overt commitment (vs. rhetoric) to the so-called strong dollar policy helped send the Dollar Index down about 13% for the year, and about 25% from its 2002 highs. The dollar recently hit a record low vs. the euro and a three-year low vs. the yen, a slide with
potentially devastating effects should it persist and accelerate.
But the greenback's malaise also bolstered the earnings of U.S. multinationals such as
. In the third quarter, the profitability of American companies rose 30%, the largest year-over-year profit growth in 19 years, a result significantly aided by the dollar's slide.
The Fed, meanwhile, was highly accommodative in 2003, lowering the fed funds rate to its lowest level in 45 years in June, where it has remained since. The 1% fed funds rate spurred record-setting refinancing activity and kept the housing market robust, further propelling consumer spending. November housing starts rose 4.5% to 2.07 million units, the highest level in about 20 years.
The Fed's "easy money" also helped corporate America work off its imbalances, largely via debt restructuring. Reflecting the improvements, the S&P Speculative Grade Index -- which mirrors trends in spreads between high-yield corporate bonds and Treasuries -- fell 40% in 2003.
Another Year, Another Boost
Looking ahead to 2004, a combination of political expediency and genuine concern about the recovery's flight path suggests policymakers will err on the side of overstimulating the economy.
Skeptics wonder if the economy will be able to maintain its forward momentum without the government's help, which will eventually abate. Others fret that stimulative policies have encouraged higher household indebtedness -- albeit arguably more "good" fixed-rate mortgage debt vs. "bad" adjustable-rate credit card-type debt -- and pushed the federal budget from surplus into record-setting deficit.
But judging by recent economic data and stock market returns, it doesn't seem as if policymakers are feeling any heat to change their stimulating ways.
"I don't see any serious effort to restrain federal outlays until 2005," said Greg Valliere, managing director of Charles Schwab's Washington Research Group. "Assuming Bush is re-elected, they'll make an effort in 2005 to curb federal spending, but in the last few weeks there doesn't appear to be much appetite for that between now and the election."
Similarly, minutes of the Federal Open Market Committee's Oct. 28 meeting revealed "members emphasized that the prospects for persisting slack in labor and other resources in combination with substantial further increases in productivity were likely to hold inflation to very low levels over the
next year or two
Following the release of those minutes on Dec. 11, many Fed watchers now believe the central bank will remain on hold through 2004, rather than start tightening in the spring as previously expected. Should the Fed wait until midyear to tighten, it runs into the problem of being perceived as meddling in the November election. Economists at Goldman Sachs forecast monetary policy "remains on hold until 2005 as growth slows in the second half of 2004 and the election creates a temporary obstacle."
However, many observers wonder how much more stimuli fed policy can provide: The Mortgage Bankers Association refinance index is about 70% below its May peak, so it's unclear how much more of a boost the Fed can provide to household spending. In addition, money-supply growth has slowed considerably, leading some to conclude the demand for money has waned despite policymakers' best efforts to "reinflate" the economy. Notably, bank lending has declined, and commercial and industrial loan activity remains moribund.
Indeed, some observers believe the Fed's policies might provide more risk to the economy than aid.
"We already see signs of rising inflation," including a weakening dollar and rising commodity prices, said Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson in Chicago. "I'm not trying to be alarmist, but the Fed has moved from a pre-emptive policy to a reactive one, and that's always dangerous -- especially for the bond market."
Similarly, with fiscal policymakers having done so much already, there are limits as to what more stimuli can be expected from deficit spending, and great debate about how much is warranted and prudent.
"From an economics point of view, there is more fiscal stimulus working its way through
the economy but not a huge amount more," said Richard Kogan, senior fellow at the Center on Budget and Policy Priorities, a nonprofit organization based in Washington, D.C.
The $87 billion special appropriation for the war in Iraq, recent passage of Medicare reform -- estimated to cost the government $2 trillion over the next 20 years -- and pending passage of both the $820 billion fiscal 2004 omnibus spending bill and a massive energy bill have fueled perceptions of government spending run amok. Government spending has climbed to 20% of GDP from 18.4% in 2001, according to Wesbury. But the bottom line is the pace of deficit spending will slow noticeably this fiscal year vs. 2003.
"In the scheme of things,
roughly $70 billion out of an $11 trillion economy is not trivial," Kogan said, referring to CBO forecasts that the federal deficit will grow to $480 billion in the current fiscal year, which ends Sept. 30. "On the other hand, it isn't big enough to really make much difference."
Kogan also took exception with the idea that government spending is unfettered, attributing it to the "egregiousness of special interests" in the omnibus, energy and farm bills. "Having money spent on pork does not mean there's an explosion of spending,
just an explosion of pork spending," he said.
If, for example, Congress were to have reauthorized extension of long-term federal jobless benefits, that would have had a more direct impact on the economy, because it's almost certain those monies would have been immediately spent.
"In a weak economy, any tax cut or spending is going to create some stimulus," said Peter Orszag, a senior fellow in economic studies at the Brookings Institute in Washington, D.C. "The challenge is to design policy changes in a cost-effective manner and that's where we've not done well."
Similar to critics of the Fed's policies, some contend the Bush administration's tax cuts and higher spending have created short-term benefits at a long-term cost, namely the record-setting budget deficit. However, while many bears (and Democrats) decried last year's tax-cut as a "one-shot" boost to the economy, the fact is there's another boost coming.
Although the 2002 tax cut was retroactive to Jan. 1, most employers only reflected the adjusted withholding tables after May, noted Robert Willens, tax and accounting analyst at Lehman Brothers. "So, most people are going to find there was excess withholding and are already entitled to inordinately large refunds next year."
Additional tax relief could come for corporations, Willens said, noting Congress is contemplating an overhaul of international tax rules that would lower the rate of taxes on earnings repatriated from foreign subsidiaries of U.S. multinationals Willens estimated there's about $400 billion of overseas earnings accumulated by
companies -- notably at firms such as
and Procter & Gamble
-- that would benefit from a change in the law.