If US Goes Over ‘Fiscal Cliff’, the Fed Has Insurance

Five Players Who Can Drive Us Over the ‘Fiscal Cliff’
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Republicans showed during the U.S. election campaign that they were true monetarists. As any true believers, they knew that the Federal Reserve's huge and unrelenting monetary easing would boost President Obama's election chances with rising jobs and household incomes.

But since that could not be said publicly, Republicans began to complain that the Fed's loose money policies were debasing the dollar. To stop that, Newt Gingrich promised during the Republican primaries in late 2011, and repeated many times since, that, if elected, he would fire the Fed Chairman Ben Bernanke.

Mitt Romney agreed, vowing last month that as president he would not reappoint Bernanke when his second term expires in January 2014. All that made no economic sense, but it was fair game in an election campaign. The dollar was not being debased.

Over the last 12 months, thedollar rose 3 percent in trade-weighted terms, and foreign capital inflows via purchases of U.S. government debt in the year to August (the latest data point available) soared 14 percent.

And there was no doubt that the Fed's policy stance was correct. With both the core and the headline inflation rates at 2 percent, an unemployment rate of 7.9 percent signaling a huge slack in the labor market, and the economy growing so far this year at a rate of 2.3 percent - well below its non-inflationary growth potential of 3-3.5 percent – there was certainly no reason to criticize the Fed for maintaining its monetary stimulus.

Financial markets also agreed with the Fed that the economy needed help. So they continued to trade the benchmark 10-year Treasury note at about 1.6 percent – a level pointing to quiescent inflationary expectations in a slowly expanding aggregate demand.

Elections are over, but nothing indicates that the Fed is ready to begin withdrawing exceptionally high money market liquidity. In fact, the Fed's pledge to maintain a virtually zero federal funds rate "at least through late 2014," is still in place.

Why is the Fed so gloomy about the growth outlook for the U.S. economy? There are two reasons.

First, there is the depressive impact of the euro zone's struggle with a seemingly intractable fiscal crisis. And then there are fears of China's protracted slowdown as its new leaders seek to reform the economy in order to generate more growth from household consumption and capital outlays.

(Read More: Changing China: The New Leaders)

Second, the Fed is setting the stage to offset an inevitable fiscal tightening at home to reduce budget deficits and stop the growth of public debt currently running at slightly more than the entire value of U.S. goods and services (GDP).

And the Fed is ready for the "fiscal cliff," too. Indeed, there is not much more the Fed needs to do to absorb the possible shock of automatic tax increases and spending cuts at the beginning of next year amounting to almost 4 percent of GDP. Zero interest rates and massive bond purchases are maximum emergency measures – a sort of an insurance policy the Fed has already taken to support growth and employment.

(Read More: Fiscal Cliff: Complete Coverage)

But whether the Republican leadership in the House of Representatives will push the Democratic White House to the edge of the fiscal precipice is another matter. I believe there will be an interim agreement to avoid tax increases and spending cuts because it will not be possible to work out a definite solution to complex issues of tax reform, Social Security, Medicare and Medicaid before the new Congress convenes next January.

No Easy Deal

The deal won't be easy, though. In fact, as things now stand, there is no room for a deal. The president wants higher taxes on people with annual incomes of more than $250,000, and the Republicans refuse to agree to such tax increases. The president is also ruling out the possibility (that might be acceptable for Republicans) to raise revenue by closing tax loopholes while leaving current tax rates unchanged.

President Obama believes he has the upper hand in this confrontation. He ran for re-election on the platform of higher taxes for the wealthy and won. That means he has a mandate Republicans might find politically too costly to challenge at the risk of plunging the economy into a protracted slowdown and destroying jobs when 23 million of Americans are already out of work.

U.S. bond markets are expecting to benefit from the messy political fight over the coming months, but scenarios of a crashing American economy are too far-fetched. The Fed has done what it takes to prevent such a dire outcome.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia