The Sequester and Its Impact on the US Economy

Back in the summer of 2011, the United States government was facing a dilemma. Without an existing budget it would be difficult to determine whether or not the United States was in fact facing a default on its borrowing capacity. After all, if you’re spending over your credit limit (budget) what’s to say that you won’t default on the debt? Hence Standard & Poor’s and Moody’s both downgraded US debt. US Government bonds went from a AAA ratings to AA, where it is now.

The net result of this was legislation that created a panel made up of 50% GOP and 50% Democrats to determine what could be cut and how. Neither side could come to terms. The GOP wanted to cut entitlements and the Democrats wanted to cut defense spending. With neither side able to agree, the next step in the process would be automatic spending cuts – also known as sequester. The irony here is that sequestration was supposed to be so horrific that no one would even consider the prospect.

Sequestration is now the law of the land as President Obama was forced (by law) to sign the sequester order last Saturday, March 2nd. In essence 85 Billion dollars will be cut from the US budget and the following areas will be affected:

· Small Business
· Education
· FDA Food Inspections
· Research and Development
· FBI and Law Enforcement

The order itself is about 83 pages in length with the net result being that just about every department in the US government will be forced to slash their budgets by up to 5%. This means furloughs or perhaps permanent layoffs for many government workers. Given that the United States just posted Jobs Numbers this past Friday and showed a gain of 236,000 jobs created; the effects of the sequester has not yet been felt in the US. Some pundits have claimed that up to 750,000 jobs will be lost. Whether or not this is the case is yet to be seen, but one thing is certain; there will be layoffs and many of them will be permanent.

So the question remains, what effect will this have on the US economy? For one, consumer spending will drop as people who aren’t working will not be buying anything that isn’t absolutely necessary. People who might have considered buying a new auto won’t be too keen on doing so if they aren’t working. So as opposed to doing so they’ll continue using the old clunker they have.

A side effect of all this is the prospect of inflation. Inflation you ask? How can that be? Let’s take a look at one example. It’s estimated that the FDA will furlough or layoff up to 1,000 food inspectors. In the United States it is illegal for any retailer to sell food that hasn’t been inspected. No retailer will risk: a.) getting fined by the government for doing so or b.) getting sued by consumers for selling uninspected food. So we have inspected and uninspected food products. What does anyone think will happen to the price of inspected food? They will go up as there are no laws defining what can or cannot be charged for such. When prices go up, what are we left with? Inflation. If that goes on long enough with no correction, the FOMC will step in and they will raise the Federal Funds Rate aka the Overnight Rate. If that happens the banks will raise their interest rates and that will kill consumer spending in the US. Unfortunately all of this acts as a domino effect on an economy that is fragile at best.

Thus far Wall Street is treating this as a famine in China, meaning that it is so far removed that it can’t possibly have an effect on us. I suspect that will change if we start to have bad economic reports in the United States. Currently at this time the market is continuing to advance even if the fundamentals aren’t supporting. What should happen if the USD advances? In theory the markets should go down. That isn’t happening right now. The USD in the past month has exceeded the 83 mark, a month ago it was trading below 80 and yet the markets are advancing. It would seem that Wall Street is having a party at our expense. The danger to any trader is that if Wall Street wakes up, a trader could be caught on the wrong side of a trade.

There are some people in the US Government that actually want sequestration. Their attitude is “starve the government” what they forgot is that we the people are the government.