Fed chairman calls fiscal cliff a threat, predicts growth if it's avoided

Federal Reserve Board Chairman Ben Bernanke issued a dire warning on Tuesday about the threat that the fiscal cliff poses to the economy. But amid the doom and gloom, he held out a silver lining: When the fiscal uncertainty lifts, the economy could be poised for solid growth.  

“The realization of all of the automatic tax increases and spending cuts that make up the fiscal cliff, absent offsetting changes, would pose a substantial threat to the recovery,” Bernanke said in remarks delivered to the Economic Club of New York on Tuesday. He added that the central bank could do little to soften the blow.

A combination of $500 billion in taxes increases and automatic spending cuts could send the economy back into a recession if the White House and lawmakers can't strike a deal to keep the country from going over the cliff within the next six weeks. Stocks reacted strongly to Bernanke's remarks, dropping to near-session lows. 

But Bernanke also suggested that the economy has underlying strength, potential that could be unleashed if lawmakers could just sort out the nation's fiscal policy. “Cooperation and creativity to deliver fiscal clarity—in particular, a plan for resolving the nation's longer-term budgetary issues without harming the recovery—could help make the new year a very good one for the American economy,” he said in prepared remarks. During a question-and-answer period following his remarks, he added, “I really have a sense that there is a lot of unused capability, not just in terms of unemployed workers, but in terms of potential products, new investments, new technologies, things that ... are not being utilized to a full extent because people are waiting to see how things will evolve.” 

Many signs point to an economy that is slowly improving despite uncertainty about the standoff in Washington that has caused businesses to tread with caution on hiring and investing.

The housing sector, in particular, appears to have turned a corner. That’s no small thing, given that the downtrodden housing market was one of the biggest drags on growth during the recession and recovery. A rise in home prices could encourage spending by making homeowners feel wealthier and thus lift the broader economy.

The labor market is also moving in the right direction. The current 7.9 percent unemployment rate is down from a peak of 10 percent reached in October 2009. That rate is not stellar in and of itself, but it built off of and sustained a surprisingly strong 0.3-percentage-point drop in the unemployment rate in September. Payroll growth for August and September was revised up by a combined 84,000 jobs in the most recent report, another sign things are moving in the right direction and that the good news wasn't a fluke.

A similar trend might be found in gross domestic product. Some firms now believe the government might revise its preliminary reading of third-quarter GDP significantly upward, to more than 3 percent from an originally reported 2 percent. In the fourth quarter, economists surveyed by Reuters now predict that the economy will grow at a more sluggish 1.6 percent annualized rate, but University of Michigan economist Justin Wolfers notes that at this point last quarter, GDP estimates were lower than the government ended up reporting in its preliminary reading. “I don’t think we actually know Q4 is a disaster yet,” he said.

Consumer confidence continues to climb in the face of looming year-end tax hikes and spending cuts known as the fiscal cliff, despite the fact there’s no small amount of uncertainty associated with the cliff. The nonpartisan Congressional Budget Office has said that failure to reach an agreement to avert it could throw the economy back into recession in the first half of 2013. 

Top congressional staffers are drafting proposals after both Democrats and Republicans found encouragement in a Friday White House meeting. But the two parties remain sharply divided on taxes, and reaching a deal won't be easy. Still, the global political risk research and consulting firm Eurasia Group put the odds of lawmakers reaching an agreement by year's end at 80 percent.

If that happens, the drag on business investment should lift, although a good deal of caution could linger if the White House and lawmakers arrive at only a temporary deal that delays some of the tax hikes and spending cuts, giving the two parties more time to try to work out a longer-term budget deal. 

Business investment fell in the third quarter, and there’s little reason to think it has improved since; business confidence has, by various measures, plunged as the cliff looms larger. A recent analysis by The Wall Street Journal found that half of the 40 largest publicly traded corporate spenders are planning to cut back on spending this year or next. Averting the cliff would be expected to cause business spending to rise again—although this may be an area where we see continued weakness in the data through the fourth quarter, if a deal is struck close to Dec. 31.

Superstorm Sandy may also have temporarily set back growth in the fourth quarter. The late-October storm charged up the East Coast, knocking out power, causing billions of dollars’ worth of damage and disrupting work in economically important New York City, New Jersey, and Connecticut. Deutsche Bank analysts cautioned last week of a possible “acute hurricane impact” on November's payroll numbers, which will be released on Dec. 7, and the Federal Reserve estimated that the storm took a full percentage point off industrial output in October.

But some experts say that Sandy's overall economic impact on the quarter could be minimal—or even positive. The disruption to economic activity is expected to be at least partly offset by the need to clean up and rebuild in the storm’s wake. “It wouldn’t surprise me if it ends up being a small positive,” said Dean Baker, codirector of the Washington-based Center for Economic and Policy Research.

The global economic slowdown is one drag on growth that isn't likely to dissipate any time soon. Eurostat, the European Union’s statistical office, announced earlier this month that the E.U. had returned to recession amid concern over its fiscal future. China has been growing only sluggishly. The Fed continues to warn of the threat to the U.S. recovery from overseas. “Strains in global financial markets continue to pose significant downside risks to the economic outlook,” the central bank’s policy-setting committee said in its October statement. 

All told, the economy is far from healed but fairly steady, despite a major storm and even more major uncertainty associated with the looming cliff.