No engine damage from a fiscal pothole

It seems to have passed the attention of a lot of the commentators that US fiscal policy has been significantly tightened. There are a range of tax increases and government spending cuts that came into force on January 1, 2013 and these will be ratified in the hours ahead once the US House of Representatives passes the compromise package that cleared the Senate yesterday.

Of course there is still some risk that the House will play a few last minute political games and not pass the package or will insist on some amendments, but either way the US economy will start 2013 with the government sector acting as a restraining influence on the overall rate of economic growth.

The main point of the compromises that have been negotiated was to reduce the extent of the fiscal tightening relative to the full effects of the fiscal cliff, which would have cut over $US600 billion (over 4 per cent of GDP) from the economy in 2013 if left unchecked.

While the hard numbers on the fiscal impact of the compromise measures are still sketchy, the Congressional Budget Office, the independent body that assesses the US fiscal position, has published a preliminary estimate that the measures that passed the Senate will cost $US330 billion to the budget bottom line in 2013 and $US353 billion in 2014. This means that the compromise has reduced the contractionary impact of fiscal policy in 2013 by slightly more than half. The fiscal tightening in 2013 will now be approximately $US280 billion or around 2 per cent of GDP.

This is a moderate and useful structural tightening of fiscal policy that will see the budget deficit narrow over the medium term, but it is not so severe as to lop off the green shoots of growth coming in different parts of the US economy in 2013.

So the end point of the fiscal cliff compromise which has unfolded in recent days is that it will probably be a good outcome for the US economy. Not too draconian, but still significant.

While the posturing and bluster surrounding the tax hike and spending increases will have no doubt undermined consumer and business confidence in the short term, when the dust settles from these frustratingly partisan discussions, the US economy is still in a slow and long recovery phase.

House prices are rising at a solid pace, helping to slowly but surely reduce the negative equity that dogged so many home owners and the banks that lent to them. While the tax increases on individuals with incomes over $US400,000 a year may dampen the upper end of the housing market, for the other 99 per cent of the population it will be business as usual.

At the same time, the seemingly unending glut of housing that was a factor forcing house prices lower from 2007 to 2011 is all but gone except in a few pockets, and housing construction is on the rise again. The 2.5 million gain in population in the US each year through immigration and natural increase provides an ongoing boost to underlying demand for housing which also has favourable economic implications that are coming through in the hard data.

While the labour market is still weak, with the unemployment rate near 8 per cent and the participation rate falling, over 5 million jobs have been created in the last few years. This is in stark contrast to labour market trends in most of Europe, where fiscal austerity measures are substantial. The rate of job creation in the US was improving through 2012 and if that trend continues as it should, it will bode well for consumer spending in 2013.

The US Federal Reserve understood the fiscal risks and has set policy accordingly. It was actually Fed Chairman Ben Bernanke who coined the phrase "fiscal cliff” in February 2012 when assessing some of the medium-terms risks for the US economy from the budget outlook.

In anticipation of the fiscal tightening, the Fed has already signalled it will be keeping interest rates at zero for at least another two years and has ramped up its quantitative easing to the point where it is now buying $US85 billion of bonds per month to keep bond yields low. Monetary policy has never been easier.

This is good news for those wishing to see the US economic recovery gain traction in 2013. And unless there are any last minute shenanigans from the House of Representatives as it debates the measures that have already passed the Senate, the most likely scenario for the US economy in 2013 is for a solid rate of economic growth with a slow but steady fall in unemployment.

The fiscal cliff has turned out to be a mere pothole.