MacroScope

‘Cliff’ deal is one part relief, one part frustration for Fed

January 2, 2013

When Federal Reserve Chairman Ben Bernanke was last in New York, he joked about his past research into the effect of uncertainty on investment spending. “I concluded it is not a good thing, and they gave me a PhD for that,” he said, drawing laughter from a gathering of hundreds of economists in a packed Times Square conference room.

Laughter probably wasn’t echoing through the halls of the U.S. central bank on Wednesday. Late on Tuesday, Congress struck a last-minute deal that only partially and temporarily avoids the so-called fiscal cliff. Bernanke and other Fed policymakers – frustrated that it took politicians so long to address tax and spending levels in the first place – were hoping Washington would agree to a bi-partisan, longer-term plan to narrow the country’s massive deficit with only modest near-term fiscal restraint. While no deal on taxes would have been far worse for the economy, the fact that Congress put off decisions on government spending and the debt ceiling for another two months simply prolongs the uncertainty that many feel is holding back investments by businesses and households.

“You basically continue this fiscal policy uncertainty that we have had for the past year or more,” said Roberto Perli, managing director of policy research at International Strategy and Investment Group. In a note to clients, Perli predicted that at best the fiscal cliff deal does not change the outlook for Fed policy, which for now consists of rock-bottom interest rates and $85 billion per month in asset purchases. But more likely, he wrote, it would lead to even more accommodation from the Fed since Republicans – smarting from a political defeat in the last few days – may prefer to let the “sequester” of large-scale spending cuts kick in as scheduled on March 1 rather than agreeing to a smaller reduction in U.S. debt. In that case, the Fed would respond by keeping rates lower for longer, perhaps through early 2016, or simply by ramping up the value of asset purchases under its quantitative easing program (QE3), Perli wrote.

In the end, it boils down to a lot of assumptions. And a lot of uncertainty.

In that same speech back in November, Bernanke said 2013 could be a “very good year” if politicians set a credible long-term budget plan, adding worries over negotiations were already damaging economic growth. “Such uncertainties,” he said, “will only be increased by discord and delay.”

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