Impact of Central Bank Actions Subdued by Threat of Fiscal Cliff

The U.S. recovery still marches along, following more of a rollercoaster trajectory rather than a straight line. The summer slowdown that started in May looked like the start of a double-dip recession to many analysts, only to post improving job and retail sales data in July, followed by disappointing job numbers in August. We have long taken the position that monthly vital signs will remain volatile as long as a high degree of global uncertainty persists. Despite massive improvements in key economic fundamentals since the end of the Great Recession, corporate and consumer attitudes have been tainted by macro concerns, particularly the European debt crisis and the fear that they may erupt into another shock.

Thus far, major shocks on both sides of Atlantic have been averted, but a lackluster recovery persists. At least a moderate turn for the better may be on the horizon as the European Union finally announced a broad “back stop” to its debt crisis by committing to buy government bonds for its hardest hit nations. This will lower borrowing costs and give these ailing economies more time to get finances in order, which in turn should keep Europe’s recession from worsening. At the same time, the Federal Reserve’s commitment to keeping U.S. interest rates low for an even longer period of time and its willingness to do more to improve recovery momentum could be another break in the macro clouds. If in addition to its recent QE3 announcement to keep interest rates low for an extended period, the Fed takes certain steps to increase the velocity of capital, these actions could have a more direct impact on the recovery. The next few months’ job numbers would likely improve as a result of these accommodative messages and moves, following the stock market’s recent positive sentiment. However, a bigger fear is the uncertainty regarding the “fiscal cliff,” which consists of the expiration of Bush-era tax cuts and automatic spending cuts scheduled to take effect in January of 2013. If not extended, these measures would deliver a one-two punch to a fragile recovery to the tune of 5 percent of GDP. The election outcome and Washington’s handling of this looming turn will likely keep a lid on much market-driven improvement in the recovery for the next several months.  Therefore, the improvement in hiring will likely be limited for the next few months.