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CNB Weekly Economic Commentary: Feb 25

February 25, 2013

To: Everyone
From: Gregory S. MacKay, Senior Vice President & Chief Economist
Date: 02/22/13

Well, here we are, staring eye-to-eye with the “Sequester”. We’ve got an economy that is moving forward at a less than desirable pace, and our employees in Washington are back to finger pointing and recession baiting.

As I recall, the Budget Control Act of 2011 required Congress’s “Super Committee” to come up with ways to save $1.5 trillion in 10 years. Failing to find $1.2 trillion over 10 years would trigger automatic spending cuts of about 10% of annual defense spending and 8% of annual non-defense items beginning in January 2013 (“the Sequester”). The threat of a recession caused by the mandated spending cuts as well as the expiring “Bush tax cuts” led to the Fed born “fiscal cliff” definition and dire warning signs from many writers, politicians, and even the Congressional Budget Office. Members of the Super Committee proposed several ideas, with none garnering enough bi-partisan support before the 2012 general elections.

With the dust settling from the election, Congress did piece together the American Taxpayer Relief Act of 2012 (ATRA 2012) which extended many Bush cuts while increasing Social Security taxes for all and income taxes on America’s top 1% of earners. But programmed spending cuts were kicked down the road to the end of February – and here we are – with no compromises in sight.

Some finagling in ATRA 2012 reduced the amount of spending cuts in fiscal 2013 around $85 billion (from $109 billion). That’s about ½% of GDP, but estimates of the total effect on GDP run all over the board. The actual cuts to affected programs are equal, and are bringing recipients as diverse as defense contractors, day care providers, special education teachers and the people x-raying your luggage at the airport together to ask for mercy… and at this point, the Democrats remain solid in their “50% spending cuts/50% tax increases” plan, while the Republicans still state they won’t take any more tax increases.

So barring any new compromise bill, on March 1, various spending cuts in most areas of the federal government begin. We won’t see any overnight changes, but slowdowns in services provided, temporary layoffs, shortened work weeks, and a large amount of angst and frustration should soon be evident. That’s what sequestration does. It puts “skin in the game” for just about everyone. Nobody’s going to be happy, but all share the pain. I’d look for another short term extension which includes something like a “Warren Buffett” tax on all incomes over $1 million, and further reductions in many programs.

Then there has to be some real work on the longer term spending plans. According to the U.S. Census Bureau, from 2010 until 2055, the 18-64 age group (earners) goes from 194 million to 235 million people. The age 65 and over group (enjoyers) goes from 40 million to 87 million people. Not so bad? Think about it another way… the U.S. goes from a 4.85 worker/retiree ratio to a 2.70 worker/retiree ratio. Who’s going to keep your cup full? There are tremendous changes to be made, and they will be in all the sacred cows… somewhere down the road.

Meanwhile, the hiccups from what I hope is a short term federal spending gap are hard to estimate. Will some of these programs be taken over by (or return to) private industry? Will weather related incidents skew the payments? or Socio-political activities? I’ll hazard a guessestimate that GDP growth doesn’t fall beneath 1% in any quarter of this year, but overall growth stays below 2%. I think the Fed remains an integral part of the process, remaining committed to its policy of monetary stimulation. Some writers are suggesting that pumping too much money into a slow growth system is inflationary as it promotes too much demand. Here’s what I think: Would you rather have the money necessary to play golf at Pebble Beach, but have no tee times available... or would you like to have a tee time but no money to pay greens fees? If sequestration lowers the amount of some services – temporarily or permanently – the Fed is going to see that there’s enough cash out there to create or find the product elsewhere. It’s little inflationary, but much better than a deflationary spiral that can severely disrupt an economy. Just ask the Japanese. I’ve said it all along… inflation, like cholesterol, is acceptable and necessary in small amounts.

And let’s not forget the other shoe that’s about to drop... I haven’t heard much about the debt ceiling since the first week of 2013. If my memory is correct, some writers are hyping the necessity of massive federal layoffs if the debt ceiling isn’t fixed by the end of March. I don’t see how our employees in Washington can possibly drop the ball twice in a month, so I’ll suggest that’s some small increase in the debt ceiling (1-2 years worth) will be part of whatever bill develops during March. I could call it March Madness, but the name’s already claimed. Stay tuned.

Stock traders are reappraising the short term outlook, as some prices seem a bit full in the face of the sequestration. Bargains are getting harder to find. At 3 p.m., for the week and year:

Dow Industrials 13979 ---- +6.7%
NASDAQ 3154 -1.2% +4.4%
S&P 500 1512 -.5% +6.0%

Some stock money slid over into Treasuries, with yields dropping a few basis points. Muni yields increased slightly during the past week as supply increased. 

  US Treasuries
Municipal Bonds
  2/22/13 2/15/13 2/22/13 2/15/13
2 Year .25% .27% .35% .36%
5 Year .83% .88% .93% .87%
10 Year 1.97% 2.02% 1.88% 1.86%