What Next for US Fiscal Policy: A Dispassionate Discussion

We detected a change Tuesday in the US fiscal stalemate.  We think that the movement toward a short-term solution, that buys time for additional negotiation, is continuing.  Despite the rhetoric, there appears to be more common ground than is widely appreciated. 

As the Republican Senator Lindsey Graham observed, the Republican Party tried taking on an unpopular law (the Affordable Care Act) with a more unpopular tactic (government closure and threat of default).   Seeing the unpopularity of the Republican actions,  many key Republican officials have quieted down or softened their rhetoric.  Paul Ryan, for example, who some tout as a presidential candidate in 2016, acknowledged that a change in health care policy is not achievable in the short-term.  

Two things seem clear.  The Republicans are beginning to look past the Affordable Care Act and the spending authority and debt ceiling issues have become linked.  These two developments will help form the basis of a compromise.  

We assume that some short-term agreement that will allow government spending to resume and default to be averted.   This is not a question of complacency, but reading the subtext (and increasingly the text) of US politics.  This will allow for negotiations.  The Republicans will likely seek spending cuts, cuts in Medicare and Social Security and reform of the tax code.  They may also press for the TransCanada pipeline.  

President Obama position is much closer to this than many of his critics and supporters may suspect.  For example, Obama's 2014 budget included cuts in Medicare payments to health care providers, and raises funds by requiring greater payments by its beneficiaries.  The President also proposed cutting Medicaid.  He also proposed linking Social Security Payments to a chained measure of CPI which would slow the benefits growth. 

This is not to say that the negotiations will not be rancorous, but rather that the partisans tend to exaggerate the differences and the lack of common ground.  It suits their purposes.  However, in reality, there is a large overlap of positions.  One key area of contention will be taxes.  Obama favors additional revenue increases, while the Republicans are largely opposed.  The bottom line is that we suspect that the end result will be additional tightening of fiscal policy. 

Perhaps we need to simply enlarge Bismark's observation that in a democracy, one should not see the way laws and sausages are made, to include fiscal policy in a presidential system.  

We suspect the FOMC minutes that were out yesterday were a bit dated.   The closure of the government, the soft private sector data that has been released (ADP, ISM, auto sales and consumer confidence) and the fiscal uncertainty, but with a greater drag, we think the slowing of the Fed's asset purchases this year is unlikely.  

While the Hong Kong Monetary Authority's decision to raise the haircut on US T-bills used for collateral is important, it is more a shot across the bow than a mortal injury.  We do not think it portends a demise of the dollar as a reserve asset or anything like that.   There remains no compelling alternative and the virtues of the dollar, such as a deep and liquid capital market, remains unaffected.  

We will not get authoritative reserve figures (by currency) for this period, until the end of Q1 2014 with the IMF's COFER data.  However, participants will closely watch the Fed's custody holdings weekly report for some insight.   Of the $5.3 trillion of Treasuries held by non-domestic investors, a little more are held in the Fed's custody account.