The Week In The US: Ready, Steady, Cut!

The revision of Q4 2012 GDP growth estimates was smaller than we expected, mainly from the positive contribution of foreign trade (revised from -0.3 points to +0.2). In contrast, final domestic private demand was revised only slightly, to 3.2% from a preliminary estimate of 3.1%. This brings full-year 2012 GDP growth to 2.2%, compared to 1.8% in 2011.

The breakdown of its components was rather similar from one year to the next: final demand from companies and households was up 3% (versus 3.1% in 2011) and public spending declined 1.7% (versus -3.1%), while the contributions from the inventory change (0.1 versus -0.2) and from net exports (0.0 versus +0.1) were relatively small. The breakdown nonetheless shows that the increase in household spending was less supported by consumption, while residential investment rebounded. Residential investment contracted each year between 2006 and 2011 but finally rebounded by 12.1% in 2012. Even so, the contribution to growth was still very small at 0.1 points in 2012. Residential investment has declined constantly in recent years, and as a share of GDP, has narrowed from a peak of 6.1% in 2005 to less than 2.5% in 2011.

New home sales in January and home prices in December confirmed the upturn in the residential construction sector. New home sales were up by over 15% m/m and by nearly 30% year-on-year, lifting the monthly sales figure to their highest level since summer 2008. The ratio of units for sale to units sold declined sharply to 4.1 in January from 5.3 a year earlier, and 7.3 in early 2011. In brief, the excess supply of housing is shrinking while demand is regaining momentum: prices have begun rising again. The S&P/Case-Shiller index for the 20 largest metropolitan areas has increased constantly since mid-2012; pace has accelerated rapidly towards the end of the year, at 6.8% year-on-year in December.

According to FOMC members, this recent trend reflects the positive payoff of the Fed’s monetary policy. During Congressional hearings, Ben Bernanke stated that “keeping longer-term interest rates low has helped spark recovery in the housing market and led to increased sales and production of automobiles and other durable goods”. The benefits of quantitative easing are clear, while the potential costs are less so, and will not hit until a more or less distant future.

The Fed is closely monitoring those inherent risks: an uncoupling of inflation expectations or poor risk assessment by private investors due to low interest rates which could trigger financial instability. But these risks are relatively small compared to the benefits of QE3. Once again, Ben Bernanke declared that the Fed did not intend to change its policy stance anytime soon. He also reiterated that the Fed is not almighty, and underscored one of the basic principles of economic policy: that it plays a vital role in supporting the economy. As Janet Yellen pointed out a few weeks earlier, the current turnaround has been very different from normal recovery phases, notably because two components that usually support growth – residential investment and public finances – are straining it instead.

In the aftermath of the crisis, state and local governments have had to cope with “unlawful” deficits, and have been forced to slash spending and raise taxes. National accounts show successive spending declines of 1.8%, 3.4% and 1.4% between 2010 and 2012. After the massive stimulus between 2008 and 2010, the federal government too has begun to cutback spending, which declined by 2.8% in 2011 and 2.2% in 2012 (as defined by the national accounts).

Ben Bernanke’s reminder came just a few days before the sequester, a series of automatic cuts to federal government spending. Decided as part of negotiations over raising the debt ceiling in summer 2011, the sequester aims to reduce spending by $1.2 trillion over ten years, with half taken from the Defence Department and the other half from other discretionary government spending.

Every year, each of these items will have to be reduced by a little more than $54bn. For the current fiscal year (October the 1st, 2012 to September the 30th, 2013), the reduction is smaller as it only covers a 7-month period. Nonetheless, it represents a combined total of $85bn, the equivalent of 0.5% of GDP. The cuts will be systematic, with either 7.6% or 8.2% chopped from each budget line.

Although there is an almost unanimous consensus against the sequester, the political stakes are so high that none of the current proposals to remove it managed to pass Congress. Even so, we should not overestimate the importance of this issue. By the end of the month, Congress must vote on a continuing resolution to keep the government funded until the end of the current fiscal year. Clearly, this will be no easy task, but it could present an opportunity to modify the sequester into better targeted spending cuts, and why not, increased revenues. Moreover, although the automatic spending cuts are bound to seize the economy, they will not bring everything to a halt in a single day. To that matter, March the 27th is a much more crucial date.

BY Alexandra ESTIOT