After a year that started with a fiscal cliff and ended with the first bipartisan budget deal in years, diminishing fiscal drag should give way to faster economic growth over the next two years, according to a new report by TD Economics.
"Despite the tax hikes in January, sequestration in March, and a federal government shutdown in October, job growth was surprisingly robust over the last year," said TD Chief Economist Craig Alexander. "With a budget deal that reduces the drag from sequestration over the next year, the underlying strength in the private sector should show up in faster economic growth over the next two years."
From 1.8 percent in 2013, TD forecasts real GDP growth to accelerate to 2.7 percent in 2014 and 3.1 percent in 2015.
From Shutdown to Budget Deal
Political discord reached a peak in October, when a failure to extend funding led to a 16-day government shutdown. Fortunately, out of the wreckage emerged a budget deal that will avoid a similar fate for the next two years.
The deal also stems the impact of the dreaded "sequester" – forced reductions in spending that were themselves a consequence of past gridlock. The deal will likely reduce the level of spending cuts in 2014 and limit the drag to real GDP growth from 0.6 percentage points to 0.3 percentage points.
"Expiring tax provisions and reduced unemployment benefits will still act as a drag on 2014, but the bottom line is that it will be less than half of what it was in 2013," noted Alexander.
Tapering is in the wings, but Fed is still two years away from raising rates...
Less impact from fiscal policy gives the Federal Reserve room to move away from its non-traditional monetary policy efforts. The Federal Reserve surprised financial markets in September by passing on the opportunity to reduce its $85-billion bond buying program. Its reason for doing so was the potential for political gridlock and fiscal drag to further set back the economic recovery.
"We had the government shutdown in October, and yet key areas of the economy defied gravity. Employment and consumer spending growth actually accelerated during the affected months. For the Federal Reserve, all of the milestones for tapering have been met," Alexander said. "The consideration now is how to taper without overly disrupting the momentum in economic growth."
To continue to support the economic recovery, the Federal Reserve may take other measures, such as lowering the interest rate on excess reserves, or lowering the unemployment rate threshold used as signal for when it would consider raising the fed funds rate. The effect would be to demonstrate the Fed's commitment to leaving short-term rates accommodative well into the future and thereby limit upward pressure on long term rates. TD Economics expects the Federal Reserve to keep the fed funds rate at its current floor until the fourth quarter of 2015.
Global growth is counting on America
As consumers, businesses and governments combine to improve U.S. economic momentum, the rest of the world will benefit as well. In fact, a stronger American recovery could not come at a better time.
The global recovery from the Great Recession has been characterized by weak growth in advanced economies and stronger growth in emerging markets. However, this began to shift in 2013, as interest rates have risen in the latter and China implements economic reforms.
"The bottom line is that strengthening U.S. domestic demand implies higher imports, which are likely to be further supported by a strengthening U.S. dollar – a side effect of the Federal Reserve easing asset purchases."
TD Economics provides analysis of global economic performance and forecasting, and is an affiliate of TD Bank, America's Most Convenient Bank.
The complete findings of the TD Economics report are available online by clicking here.