Fiscal Cliff description

Over the Edge - The Looming Fiscal Cliff

November 16, 2012

By Mortgage Market Guide

"Well, we're not in the middle of nowhere, but we can see it from here..."
Thelma & Louise (MGM, 1991)

With the Presidential election behind us, Washington now has to deal with some pressing issues that could severely impact economic growth in the U.S., potentially leading us into another recession. Perhaps the most daunting task Congress has is to hash out the looming "Fiscal Cliff" set to occur in 2013 if the House and Senate fail to come up with a resolution by midnight December 31.

Knowing you may be getting some questions from clients and referral partners, here's a brief look at what the Fiscal Cliff means and how it could impact the economy.

What is the Fiscal Cliff?

The term Fiscal Cliff was coined by Fed Chair Ben Bernanke to describe the "massive fiscal cliff of large spending cuts and tax increases" that would take place on January 1, 2013 if no deal is reached by the House and Senate. Those cuts and increases include:

• Last year's temporary 2% payroll tax reduction expiration resulting in an equivalent increase for workers
  
• A shift in the Alternative Minimum Tax (AMT) that would take a larger chunk out of the pockets of individuals, corporations, estates and trusts
  
• Spending cuts enacted by Congress as part of the debt ceiling deal of 2011 will go into effect, which would include ending many government programs and deep cuts in the defense budget and Medicare in addition to new taxes pertaining to President Obama's health care law
  
• A number of tax breaks for businesses and household cuts from 2001-2003 expire, including long-term jobless benefits

Potential Impact on the Economy

The Congressional Budget Office (CBO) estimates that if the spending cuts and tax breaks expire, it could negatively impact the economy in any number of ways.

• First, an estimated $600 billion may be taken out of the U.S. economy in 2013 if spending cuts are enacted and tax cuts expire, pushing the country into a recession.
  
• Second, the CBO anticipates if all the expected fiscal tightening occurs, it would impact GDP negatively; even after adjusting for inflation, the CBO believes GDP could fall by 0.5% - reflected as a decline in the first half of 2013 and renewed growth at a moderate pace later in the year.
  
• Lastly, the CBO says that the contraction in the U.S. economy could cause the Unemployment Rate to rise to 9.1% by the fourth quarter of 2013.

When you factor all the potential negatives into the equation, it's easy to see why the Stock markets seem to be on hold, following nice gains earlier in 2012. In fact, the closely watched S&P 500 slipped as much as 5.5% since the election, as cash shifted over into the safe haven of the U.S. Treasury markets. Many investors worry a compromise will not be reached surrounding Fiscal Cliff issues, since the balance of power remains as gridlocked as ever following President Obama's re-election and a Republican controlled House.

Possible Solutions

But doom-and-gloom scenarios are not a forgone conclusion. Leaders from both parties have made recent statements about how the issues might be addressed. Alluding, of course, to the many details that need hashing out before an agreement can be reached.

• One option may be Congress enacting another stopgap measure, pushing the fiscal cliff deadline down the road and buying time for the new members of Congress to be sworn in and politicians to discuss broader solutions.
  
• A second option would require Congress to extend the Bush Tax Cuts or the majority of the other tax cuts set to expire, again, pushing back the spending cuts. This option eliminates much of the economic hit - and may provide an important signal to the markets - showing there's at least some spirit of cooperation left in Washington, D.C.
  
• The least desirable option would be for Congress to strike a broader bargain after January 1, 2013 - a scenario in which Congress makes retroactive changes. In this sense, the term Fiscal Cliff isn't really accurate. Instead, the country would face more of a Fiscal Ramp - minimal change at first, growing gradually worse as the year drags on. Congress could conceivably drive down the ramp a bit and then put the car in reverse by striking a deal and making it retroactive.

We at the Mortgage Market Guide feel some sort of compromise will be reached to avert the major problems. As you discuss the issues with your clients and strategic partners, remind them it seems highly unlikely Congress will ignore an issue that impacts so many facets of the economy. even if compromise is reached on the major issues, there may still be fallout from the minor ones in the form of slowing economic growth.

However, there's also reason to be hopeful, as rates remain incredibly low, housing is still recovering ground in many markets, and jobs are on a slow, steady upward trend. There's no question that the economy has a long way to go before it's fully functioning again, but we remain optimistic as we look at the year ahead.

Be watching for our regular release of the Annual Forecast!