What is the US fiscal cliff?
The US risks seeing an already weak economic recovery fade away as it has so far been unable to find a solution to a series of automatic cuts and tax increases – referred to as the fiscal cliff – that will take effect next January.
The term ‘fiscal cliff’ refers to a combination of spending cuts and tax increases due by early 2013 in the US. The tax increases result from a number of previously introduced tax cuts that will expire by the start of 2013, while the spending cuts are mostly being triggered by the ‘sequester’.
The sequester is a budgetary enforcement tool originally introduced in 1985. It became of current interest because it was also included for enforcement within the budget control act of 2011.
In August 2011, the US Congress had agreed to raise the US debt limit but the deal also included provisions for spending cuts and a joint select committee was asked to come up with another $1.2 trillion in deficit cuts spread over 10 years. This committee, however, failed to reach this target in November 2011.
It is now envisaged that the sequestrations will be triggered as part of the enforcement for the 2011 Act. The sequester is an automatic flat $109 billion yearly cut in spending, to take effect next January 2, designed to force congress to achieve a balanced deficit reduction plan. These automatic cuts are imposed across a number of federal programmes and will have the effect of tightening fiscal policy at a time when the economic recovery seems to still be unable to stand on its own feet.
The Congressional Budget Office estimates that the combined effect of the spending cuts and tax increases, plus the resultant economic feedback, could lead to a fiscal contraction in the region of $560 billion between 2012 and 2013 and the magnitude and the timing of such a contraction will most certainly hit US GDP growth negatively.
The US is the largest global economy so imagine what dampening effect that would have on the rest of the world economy – you will have come across a saying if the US sneezes the rest of the world will catch a cold.
Forex investors holding exposures in US dollar will also be affected by currency fluctuations – it depends how events will feed into currency market behaviour.
The US faces a choice between building a stronger long-run fiscal position and growth but jeopardise short-term growth and an already doubtful recovery by allowing the tax increases and spending cuts to come into effect. The CBO projects that calendar year 2013 growth would be reduced to 0.5 per cent and so increase the possibility of recession.
Alternatively, the US could avert short-term negative impact by avoiding the fiscal cliff at the cost of higher debt and interest payments and increase the risk of seeing the US face a crisis similar to the eurozone’s. In this scenario, the CBO estimates project GDP growth for the calendar year of 2013 would be in the region of 4.4 per cent.
The choice between these alternatives is already quite bleak but it is worsened by a political inability to find common ground in an election year (elections are due next November). Given the sensitivity of the issues involved – tax increases, spending cuts and others – Congress has so far been unable to make it through this bottleneck.
While at the surface one should expect such event risk to weigh on USD’s support this should be somewhat balanced against the safe haven role the USD tends to have.
However, the effect on the USD will largely be a function of what political response the US government will in the end resort to.
A reactionary approach, as opposed to a proactive approach, should be expected to impact negatively on the USD. Kicking the can down the road is something the eurozone is accused of and we have seen the effects on the euro. On the contrary, a clear deal for the deficit cuts required over the 10-year period should be positive for the USD.
With the US having to digest an election, a seemingly feint economic recovery and the threat of debt and further downgrades will likely keep US policymakers uninterested in a strong USD. If we had to focus on the EUR/USD while the eurozone never seems to stop surprising negatively, the lead that the USD has been holding against the euro since May 2011 probably opens the door for some correction. While downside risks remain for the pair we could most probably be aiming for levels around 1.30 levels in the coming year.
Will the US avert this fiscal cliff? Most likely yes, but it is how policy makers tackle the upcoming elections and this fiscal conundrum that will most likely impinge on the markets – how policy makers can make a way with uncertainty and how swiftly this will happen.
Rudolf Muscat is a senior trader at RTFX Ltd.