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Fed poised to act as 'fiscal cliff' nears

Federal Reserve chairman Ben Bernanke

YURI GRIPAS/REUTERS

Further economic stimulus by the U.S. Federal Reserve looks increasingly likely, as a greater number of policy makers express doubts about the recovery, and a new report warns that Congress could plunge the United States into another recession.

The Congressional Budget Office, a non-partisan agency that calculates the fiscal impact of U.S. legislation, said Wednesday in its latest economic forecast that a combination of tax increases and budget cuts scheduled for Jan. 1 could result in an economic contraction of 0.5 per cent.

In Washington, this confluence of previous and unconnected political actions is called the "fiscal cliff," and unless it's avoided, the unemployment rate will rise to 9.1 per cent next year from the current 8.2 per cent, the CBO predicts.

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"Economic output would be greater and unemployment lower in the next few years if some or all of the fiscal tightening scheduled under current law was removed," the report said.

The CBO's usual role is to urge fiscal restraint. The U.S. is set to record its fourth-consecutive deficit of $1-trillion (U.S.), and the country's debt is headed for its highest level since 1950. But previous calls for restraint came as the economy was growing. The cost of austerity now appears too high.

The CBO's updated analysis promises to reverberate throughout Washington, which is fixated on a presidential campaign where the budget deficit has emerged as a primary issue.

The White House and congressional Republicans again traded political shots over who is to blame for policy deadlock, underlying the consensus view that the fiscal cliff will remain unresolved until after the November election at the earliest.

The prospect of further uncertainty is causing discomfort at the Fed, where central bankers are expressing greater concern that the economy is faltering. Mr. Bernanke and the rest of the Fed's policy committee opted against further stimulus earlier this month.

The policy committee members indicated at the time that they needed more data to determine whether the economy really needed another boost from lower interest rates.

But minutes of that meeting, released Wednesday after the typical three-week delay, show the Federal Open Market Committee was closer to adopting new stimulus measures than most analysts previously thought.

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"Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial strengthening in the pace of economic recovery," the minutes said.

That's an unusually clear statement about the Fed's intentions, implying a clear majority on the 19-member committee is leaning toward new steps, perhaps as soon as the FOMC's next meeting on Sept. 12-13. The minutes indicate that policy makers favour either extending their pledge to keep borrowing costs near zero until at least the end of 2014, or the launch of a third bond-purchase program.

"The majority of voters on the FOMC are moving toward an additional monetary easing move," Kevin Logan, chief U.S. economist at HSBC in New York, said in note to clients. "Only a substantial and sustained improvement in economic growth and labour market conditions would prevent some sort of move in the near term."

Economic indicators have been better since the Fed opted to stand pat on Aug. 1. In particular, a subsequent report said the U.S. economy added 163,000 jobs in July, ending a three-month streak of especially weak job creation.

But the July figure only looks strong compared with the second quarter, when the U.S. economy added an average of 73,000 a month. To keep up with changes in the labour force, economists say the U.S. must generate about 100,000 jobs a month; to meaningfully lower the unemployment rate, they say the economy must create jobs at twice that rate for an extended period.

"Many members expected that at the end of 2014, the unemployment rate would still be well above their estimates of its longer-term normal rate," the minutes said. In addition, a "number of members" expressed concern that "if the recent modest rate of economic growth were to persist, the economy would be less able to weather a material adverse shock without slipping back into recession," the minutes said.

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Falling over the fiscal cliff likely would constitute such a shock. The combination of tax increases and spending cuts set for next year is estimated to be the equivalent of about 4 per cent of gross domestic product.

Most at the Fed think the economy is too weak to absorb such a blow. According to the minutes, many policy makers see the possibility of a "sharper-than-anticipated U.S. fiscal consolidation" as a "significant downside" risk to the economic outlook.

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About the Author
Senior fellow at the Centre for International Governance Innovation

Kevin Carmichael is a senior fellow at the Centre for International Governance Innovation, based in Mumbai.Previously, he was Report on Business's correspondent in Washington. He has covered finance and economics for a decade, mostly as a reporter with Bloomberg News in Ottawa and Washington. A native of New Brunswick's Upper St. More

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