What is the Fiscal Cliff and How is it Affecting the Economy

The fiscal cliff that is the current hot topic in the news is a combination of automatic spending cuts and tax hikes that are scheduled to go into effect at the end of 2012 and the beginning of 2013. The spending cuts were triggered when congress failed to reach a deficit reduction agreement during last years debt ceiling debate.

Fiscal CliffThe tax increases are also automatic because Congress failed to make the “Bush Tax Cuts” permanent opting instead for a more politically expedient temporary tax reduction. In other words, they “kicked the can down the road” and it landed at the end of 2012. Perhaps they were hoping the Mayans were right and the world would end before  they had to deal with the issue again.

But so far the world hasn’t ended but fiscally the end may be nearer than we think.

What Economic Impact will the Fiscal Cliff Have?

The Congressional Budget Office (CBO) – issued a report last Tuesday saying that if Congress doesn’t deal these issues by Dec. 31, a combination of  $560 billion in budget cuts and tax hikes will result. The CBO is convinced that this is a lethal combination that will “probably” send the US into recession.  On the other hand, in the long run it may actually be beneficial, in that it would cut the US federal deficit in half.

According to a recent Rasmussen Report, Sixty-two percent (62 percent) of consumers believe the United States is already in an economic recession. And many economists believe that the U.S. is headed in that direction. In this case the people may be ahead of the economists.

The Fiscal Cliff is Already Affecting US

According to the Wall Street Journal,

New data this week provided more evidence that the economic recovery is sputtering for the third year in a row. Layoffs are rising, factory output is falling and consumers are cutting spending amid rising uncertainty. Moreover, those warning signs mostly predate the worst of the recent turmoil in Europe, which has hit financial markets and hurt demand for American products overseas.

According to Lakshman Achuthan, Chief Operating Officer of the  Economic Cycle Research Institute,   “The broad measures of  output, sales, income, and now jobs  are all turning down together and that is a sign of an economy that is not reviving but rather slowing.” He goes on to say, “For three months we’ve had income growth so low that it is lower than it was at the start of each of the last ten recessions.”  In other words, we may be in a recession already but typically it takes economists 6 months to be sure and “officially” declare a recession is in progress. Achuthan says, “Typically it’s half a year before you get your first negative GDP print”.  That means that all these other indicators, like  output, sales, income, and jobs, are already recessionary low but GDP just haven’t gone negative yet.  But unless we get some massively good news quickly it will turn negative just in time for the election.

Business Week Says,

Companies are starting to delay hiring and spending out of concern that Congress won’t reach a compromise in time to avoid automatic tax increases and budget cuts that would pull billions of dollars of purchasing power out of the economy.

So fear of the impending fiscal cliff is already having an effect. On Thursday, the Labor Department said more people filed for unemployment benefits last week. So when June totals are in, it could be the fourth straight month  of weak hiring.

In addition, the major liquidity pumped into the economy due to the Quantitative Easing of  QE1, QE2 and Operation Twist is starting to dry up. With less liquidity market forces are beginning to take hold again and the economy is slipping back into recession. One sign of the decreased liquidity is Disinflation i.e. inflation levels are dropping the most recent Inflation numbers show a decline from 2.3% to 1.7%.

In Q1, the FED bought $1.7 Trillion in relatively worthless mortgage securities from banks thus shoring up their balance sheets and boosting the Money Supply. In QE2, the FED bought $600 Billion in Treasury Bonds thus tiding the Government over for a while. And in Operation Twist the Fed sold $400 billion of the Treasury Bills that it owned (that were to mature  in less than three years) and an equal amount of longer-term Treasury bonds (that mature in  six to 30 years). At the same time, the Fed is reinvesting the proceeds from its  mortgage-backed securities that mature into new ones. So Operation Twist extended the maturity of the FEDs Debt. The goal was to push long-term interest rates lower which theoretically would encourage investment and hiring.

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