STOCK MARKET WATCH -- Wednesday, 5 June 2013

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5. Fiscal Headwinds: Is the Other Shoe About to Drop? By Brian Lucking and Daniel Wilson

http://www.frbsf.org/publications/economics/letter/2013/el2013-16.html?utm_source=mailchimp&utm_medium=email&utm_campaign=economic-letter-2013-06-03

Federal fiscal policy during the recession was abnormally expansionary by historical standards. However, over the past 2½ years it has become unusually contractionary as a result of several deficit reduction measures passed by Congress. During the next three years, we estimate that federal budgetary policy could restrain economic growth by as much as 1 percentage point annually beyond the normal fiscal drag that occurs during recoveries...

The current recovery has been disappointingly weak compared with past U.S. economic recoveries. Researchers and policymakers have pointed to a number of potential causes for this unusual weakness, including contractionary fiscal policy. For example, Federal Reserve Vice Chair Janet Yellen (2013) argues that three tailwinds that typically help drive strong recoveries—investment in housing, consumer confidence, and discretionary fiscal policy—have been absent or turned into headwinds this time.

Changes in fiscal policy have been substantial over the past two years, including passage of the Budget Control Act of 2011, which led to sequestration spending cuts. In addition, temporary payroll tax cuts expired and income tax rates for higher-income taxpayers rose following passage of the American Taxpayer Relief Act of 2012. Two important questions are how much has federal fiscal policy been a drag on growth in the recovery to date and to what extent will it affect growth over the next few years? Moreover, is this fiscal drag unusual or part of the normal pattern in which government spending tends to fall and tax collections tend to rise as economic activity gains momentum?

In this Economic Letter, we examine these questions by estimating what fiscal policy would be if it followed historical patterns in the relationship between fiscal policy and the business cycle. We then compare this historically based estimate with actual fiscal policy during the recession and recovery to date. We also look at government projections of fiscal policy over the next three years to see how these compare with estimates based on the historical norm. Finally, we discuss what these trends in federal fiscal policy imply for economic growth.

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