Recession imminent if ‘fiscal cliff’ of tax hikes, budget cuts not averted, CBO says

The U.S. economy will hurtle into a recession if Congress fails to avert a series of tax increases and budget cuts due in January, the Congressional Budget Office said Wednesday, warning that a fiscal impasse would have consequences even more dire than previously forecast.

The CBO’s gloom sparked another round of political finger-pointing but failed to cast much of a shadow over financial markets. That’s because the Federal Reserve is inclined to act “fairly soon” to boost the slow pace of economic recovery, according to minutes the central bank released Wednesday. Moreover, new data showed signs of modest improvement in the housing market.

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Falling off the 'fiscal cliff' into recession?
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Falling off the 'fiscal cliff' into recession?

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All of which raises a quandary for some economists: If Congress is about to steer the nation over what is being widely dubbed a “fiscal cliff” by failing to agree on a budget, then maybe the Fed should save its ammunition. Let things get really bad, then act.

“Why do you want to waste your ammo now if you’re going to go off a fiscal cliff at the beginning of next year?” said Edward Yar­deni, president of Yardeni Research, urging restraint by the Fed. By revving up the economy before it reaches the cliff, Yardeni said, “maybe [the Fed] thinks we can do an Evel Knievel and jump right over it. But I don’t get the logic of that.”

But the Fed minutes indicated that most of the members of its Open Market Committee think otherwise.

“Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery,” said the minutes of the meeting, held July 31 and Aug. 1.

The Fed debated a variety of tools for boosting growth, including extending its commitment to ultra-low federal funds rates past 2014, linking those rates to economic indicators, launching a new round of purchases of Treasury and mortgage securities, and initiating a plan to encourage bank lending.

With just 21 / 2 months left until the presidential election, it may be too late for monetary or fiscal policy to significantly alter the state of the economy before voters head to the polls. But actions taken now by the Fed or Congress might still influence whether voters believe the economy is on the right track.

A steep cliff might not look like the right direction, though, and the CBO said businesses might delay hiring or investment if the outlook is threatening.

In its report Wednesday, the CBO warned that the nation would be plunged into a significant recession during the first half of next year if Congress fails to avert nearly $500 billion in tax increases and spending cuts set to hit in January.

The massive round of New Year’s belt-tightening — known as the “fiscal cliff” or “Taxmageddon” — would disrupt recent economic progress, push the unemployment rate back up to 9.1 percent by the end of 2013 and produce economic conditions “that will probably be considered a recession,” the nonpartisan CBO said.

The CBO’s economic outlook is considerably darker than the forecast the agency released in January, when it predicted that the fiscal cliff would trigger a mild recession in the first half of 2013, with the economy shrinking by 1.3 percent. Now the agency foresees a contraction of 2.9 percent in gross domestic product, “similar in magnitude to the recession of the early 1990s.”

Republicans, including presidential candidate Mitt Romney, want to postpone the biggest chunk of the cliff — $331 billion in tax hikes — to give Congress time to overhaul the tax code.

They have also sought to pin the scheduled deep cut in military spending on President Obama, working to undercut his support in electoral battlegrounds where defense spending is key to the economy. The Republican-led House passed legislation in the spring that would shift those defense cuts onto domestic programs.

Democrats, including the president, want to avert tax increases for those making less than $250,000 a year but say they will not avert tax increases for those making more, arguing that higher tax revenue is needed to help close deficits.

House Speaker John A. Boehner (R-Ohio) said the CBO report underscores why the House in August passed legislation to avoid tax increases for Americans at all income levels. The Democratic-led Senate passed a competing bill to halt tax increases only on income less than $250,000.

“Instead of threatening to drive us off the fiscal cliff and tank our economy in their quest for higher taxes, I would urge President Obama and congressional Democrats to work with us to stop the coming tax hike that threatens our economy and replace the looming defense cuts with common sense reforms,” Boehner said in a statement.

The White House turned the tables, responding in a statement that the report “only reinforces the urgent need for House Republicans to follow the Senate’s lead and pass a bill that gives middle-class families the confidence that they won’t see their taxes go up at the beginning of next year.”

The CBO report is gloomier than the agency’s January forecast in part because of a decision by Congress to steepen the fiscal cliff by extending a temporary payroll tax break and emergency unemployment benefits, which are now also set to expire in January.

In addition, CBO analysts have concluded that the underlying economy is weaker than previously predicted.

“The magnitude of the slowdown we’re discussing next year is significant,” CBO Director Douglas Elmendorf said at a morning briefing. He noted that going over the cliff could cost the nation about 2 million jobs. Elmendorf said the unemployment rate could remain stuck above 8 percent through 2014.

The agency says growth would be weaker than previously forecast, with the economy expanding by an annualized rate of just 1.9 percent in the second half of 2013.

Even without a year-end fiscal crisis, the Fed “anticipates a very gradual pickup in economic activity over time and a slow decline in unemployment,” with low inflation, according to the central bank’s minutes.

But the Fed members confessed “an unusually high level of uncertainty” about the outlook, noting that Europe’s sovereign-debt and banking crisis and the specter of “a sharper-than-anticipated fiscal contraction in the United States” meant that expectations were “tilted to the downside.”

Republicans have been increasingly vocal about their desire to avert the $55 billion in planned reductions at the Defense Department in January. In Tampa this week, a drafting committee inserted language into the party’s official platform calling the defense cut “a disaster for national security” and blaming Obama for its creation.

The platform does not address the equally stark $55 billion across-the-board cut scheduled to hit domestic programs or offer guidance on how to avert the cuts without worsening the deficits.

While the CBO report outlines the consequences to the economy of failing to reach a deal to avert the cuts and tax increases, it also demonstrates the flip side of continued gridlock: one of the biggest rounds of deficit reduction in modern history.

If Congress does nothing and allows taxes to rise and spending to fall, the CBO predicts the 2013 deficit would plummet to $641 billion instead of exceeding $1 trillion for a fifth straight year.

For the current fiscal year, which ends Sept. 30, the CBO predicts the deficit will be just over $1.1 trillion, down slightly from previous projections, thanks to better-than-expected tax collections and lower spending as the war in Iraq has drawn to a close and the effects of the 2009 economic stimulus have waned.

The national debt is nonetheless growing apace, with debt owed to outside investors set to hit 73 percent of the overall economy by the end of September. That’s the highest level in more than 60 years and nearly double the level in 2007, before the onset of the recent recession.

Rosalind S. Helderman contributed to this report.

 
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