What the fiscal cliff could mean for the US and global economy

With the US fiscal cliff less than three months away, the International Monetary Fund has chimed in this week with its concerns for both the US and the global economy as a whole. The US is edging towards an enormous fiscal tightening the like of which we haven’t seen since 1947. The nerves, pressure and speculation surrounding the issue will only going to intensify as US politicians argue and stall their way through the final quarter of the year.

The IMF has estimated that if a deal isn’t reached to avoid a full-blown fiscal cliff, then the US could well plunge into recession next year. The organisation estimates that the US economy will grow by 2.1% in 2013, while the impact of the fiscal cliff would weigh on GDP by 2.2%.

While the fiscal cliff does not appear to threaten a global recession next year, it would certainly have a significant impact; rating agency Fitch has estimated that it would cut global growth in half. As far as eurozone growth is concerned, developments from within the region could easily tip the IMF’s 2013 eurozone GDP forecast of 0.2% well and truly into recession territory regardless of the fiscal cliff. However, the organisation sees the failure to reach a compromise on the fiscal cliff knocking 0.4% off growth, which would seal the deal regardless.

If an agreement between the Republican controlled Congress and Democrat controlled Senate, it is highly unlikely that the payroll tax cut will be extended - there appears to be consensus on this issue. The expiration of this tax cut then will likely shave 1.0% off US GDP, which is nearly half the amount that the IMF is estimating of a full-blown fiscal cliff. This would leave global growth down around 2.6% in 2013, instead of the 3.6% the IMF is anticipating on the assumption a deal is reached. Unless US politicians pull a rabbit out of their collective hat, the fiscal cliff issue is likely to end in pain for all concerned, just how much pain is the real question.

Richard Driver

Currency Analyst

Caxton FX 

US fiscal cliff a major danger to the US dollar

The most immediate danger to the US dollar is quite clearly posed by QE3. The US Federal Reserve’s monetary policy outlook should be a little clearer after Bernanke’s speech in Jackson Hole this afternoon. If it is not, then the Fed’s meeting and press conference on September 13^th should yield plenty of clues.

Whilst data over the past month or two suggests that US economic growth is recovering from its slumber in the first half of 2012, there is plenty of uncertainty ahead with the US ‘fiscal cliff’ drawing closer.

What is the fiscal cliff? The end of 2012 will see tax cuts come to an end and spending cuts dramatically, which are expected to weigh on US GDP dramatically. Tax cuts that will expire include a 2% payroll cut for workers and tax breaks for businesses, while tax hikes related to President Obama’s healthcare law will also kick in. The Congressional Budget Office estimates that the effects of all this could be a reduction in US GDP by a staggering 4.0% in 2013, while two million jobs could be lost resulting in a 1.0% rise in unemployment. So with the fiscal cliff capable of plunging the US economy back into recession, the stakes are extremely high.

                                                                                                                              

The US economy is faced with taking the pain and addressing its fiscal position in an early but huge hit, or spreading the pain over a longer period in order to safeguard a still fragile recovery (a familiar debate to followers of the UK political approach to austerity). As last year’s ‘debt ceiling’ debacle demonstrated, deadlock in the US political system can cause huge delays to major policy decisions.

In addition, this fiscal cliff issue comes in the context of an election year, so there will be no decision made on how to approach tax and spending moving forward until the leadership is determined in early November. A stop-gap measure to delay the tax rises may well come before the end of the year but you can be confident that any decision that is made will come right down to the wire.

What are the implications for the US dollar? Well, as ever there are two sides of the coin. The concerns over the US economy and the fears of recession could drive the dollar down in line with its deteriorating economic fundamentals. Contrastingly, the threat to the world’s largest economy could see the market flood back into the safe-haven US dollar. Inevitably, both strategies will be adopted but which truly prevails is uncertain.

Our bet is that the US dollar will be hurt by the fiscal cliff issue. This will likely be the case whether the US ‘goes over the cliff’ or whether delaying tactics are adopted. The can-kicking that has been evident in the eurozone has been a major weight on the euro over the last couple of years and the market response to more of the same from US policymakers will be the same.

However, the fiscal cliff is by no means the sole point of focus for the financial markets in the second half of 2012. Of course, this all comes as the eurozone debt crisis reaches new levels of seriousness. Indeed, we doubt that the fiscal cliff issue will be enough to stop the EUR/USD pair dropping significantly below $1.20 by the end of the year. The fiscal cliff will weigh on the dollar, but not to the same extent that the debt crisis will weigh on the euro.   

Richard Driver

Currency Analyst

Caxton FX