Last Thursday we learnt that dissent within the Fed is on the rise, which led markets to assign a higher probability to a withdrawal of monetary stimulus over the foreseeable future. On the fiscal side, the deal struck to avoid the fiscal cliff has postponed a significant portion of the negotiations. Thus, economic policy changes should be expected to have a very important impact on expectations and markets this year, across both monetary and fiscal dimensions. After more than 4 years of living dangerously, this might be the year of responsibility…

On the fiscal side, the fiscal cliff could have produced a 4.5% of GDP fiscal adjustment, but most of it was avoided or postponed, which means there is still a lot to negotiate and decide. Moreover, consensus was that a grand bargain to avoid the cliff would produce a serious fiscal adjustment (at least over a number of years), to then focus on reforming the tax code to make it more efficient and conducive to investment and growth. There was no grand bargain. Moreover, the political dysfunction shown for the second time last month does not bode well for the outlook on these. On the positive side, there is an interpretation that claims that what to do with the Bush tax cuts was the most difficult political issue, as neither party wanted to yield on its own principles on such a prominent general taxation level decision. This issue has been resolved by letting the temporary cuts expire only for the top 2% of the population. Now the negotiations are on issues everybody agrees are difficult to resolved but need to be resolved to avoid a serious fiscal crisis. True that market interest rates are not putting any pressure on the US political system to think about a fiscal adjustment, though they have started to come up.

The debt-ceiling debate should reach a peak by the middle of March, when it is estimated to be binding. The automatic spending cuts would happen by the beginning of March. Thus, by the second half of February we should expect signals on whether politicians can only produce last minute bad agreements on these issues, or whether a more optimal policy framework can be put in place. These two issues are very relevant for the path of real interest rates and for the incentive scheme for capital repatriation and investment. Clearly, the medium-term growth outlook should be affected by the decisions taken on these issues. When it comes to the medium-term we are optimistic, but the timing of policy decisions needs to be monitored as it can produced non-trivial surprises for the markets.

On the monetary side, it is difficult to overstate the importance of monetary expansion globally over the last few years. 2012 was the year of Mario and Ben. Maybe it sounds like a computer game because monetary policy these days is expected to work as a game: keep pressing A, and we accelerate and avoid a crisis. As we have argued before, monetary policy cannot solve fundamental problems, but it can shock the system to coordinate expectations out of a crisis, or help postpone the crisis dynamics buying time while reforms fix the fundamental issues. Ben Bernanke did the former in early 2009. Mario Draghi accomplished the latter in 2012. The Fed has kept increasing its bet on monetary expansion ever since. Monetary policy is a key element in market valuations these days.

Yesterday the Fed minutes from their December meeting produced a very relevant signal on how they will think about their intervention. A set of rules had been announced in December, which the market had interpreted as applying to all monetary expansion. Now it is clear that the new rules (levels of unemployment and inflation that would push the Fed to withdraw monetary stimulus) apply mostly for the policy rate decision, and not necessarily to the quantitative easing side of their policies. In other words, it is now more likely we see the Fed’s balance sheet stop to grow and potentially contract before unemployment fell through the 6.5% threshold or inflation rose through the 2.5% threshold (for the PCE). Many in the markets took this discussion to signal the beginning of the end when it comes to monetary stimulus, which has been like a drug to markets since 2009.

We think it is easy to over-react to this type of news, as we do not see anything imminent. But how and when to withdraw is clearly part of the discussion within the Fed, as it should be.  And because this is totally uncharted territory, in terms of the size of central banks’ balance sheets, the way and timing of these withdrawals should at least be tremendously important short-term phenomena.

In sum, policy debates and negotiations in the US have become even more important. At least they will dictate short-term gyrations in the markets, but they could have more fundamental effects as well. To the expected  analysis of fundamentals and policy, one should definitely add an extra effort on US politics and policy.

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