With economic growth and short-term interest rates increasing steadily, issues in Washington are taking on added importance for the outlook.
In some areas, we have setbacks. The nomination of Harriet Miers to the Supreme Court is in disarray. There’s little hope for broad structural improvements on Social Security and the spending process. And growth-oriented tax-reform remains blocked by the congressional scoring system, which doesn’t link tax improvements to the growth rate.
In other areas, we have progress. The China debate has taken an important turn away from protectionism. The Katrina rebuilding effort reveals government clumsiness, but there will be less actual spending than feared. And the transition to a new Fed chairman should go smoothly.
Let’s begin with the Fed nominee. Current Council of Economic Advisor’s chairman Ben Bernanke has been nominated to replace Alan Greenspan at the Federal Reserve. Markets will probably welcome his credentials, his independence from the administration, and his respect internationally, along with the likelihood of an expeditious confirmation. While the dollar might focus in the very short term on whether Bernanke is “hawkish” on interest rates, my view is that interest rates will be high enough when he takes over for the transition not to have a big impact on the dollar. Greenspan has already done the heavy lifting in the inflation fight without too much market disruption and only a moderate inflation bulge.
Meanwhile, Washington’s progress on structural reforms remains one of the key medium-term variables for U.S., and even global, growth.
For a few weeks after Katrina, Republicans and Democrats were vying to see who could promise more spending. This recklessness is no longer as intense. The $60 billion initial Katrina appropriation hasn’t been spent as fast as feared, and the $200 billion aid figure isn’t likely to be approved. Indeed, there’s been a healthy backlash on spending. And whatever the final number is for Gulf Coast relief, the outlays will extend over multiple fiscal years and might be redirected or made more effective over time.
In my view, tax policy remains the top problem today, with little likelihood of budget or tax reform coming in 2006. The president’s tax commission will make formal recommendations to the Treasury in the next few days, and while relief from the alternative minimum tax might be recommended, substantial tax-reform legislation will not make progress next year due to a congressional scoring system that does not link tax improvements and expected growth. (Consider why it should: Since the 2003 tax cuts, government receipts have grown very fast, reducing the deficit. Receipts were 14.6 percent higher in the 12 months through September than they were in the previous 12 months.) There is, however, a better-than-even chance of a constructive tax-reconciliation bill coming in 2005, one that would extend from 2008 to 2010 the current capital gains and dividend rates.
One final point on the outlook is that Treasury Secretary John Snow’s recent trip to China was an important step away from protectionism. Snow and other top administration staff broadened the debate with China from an exchange-rate focus to one that includes a discussion of financial-system reform and more-open markets. Simply, the debate is now more balanced. China will probably be able to show progress in these other areas, whereas it could not agree to currency revaluation (because it would bias its own economy against rural areas and in favor of urbanites, the opposite of its primary economic goal.)
That said, today’s economic fundamentals are sound. Growth is holding steady at 3.5 to 4 percent. Gold and oil prices are down, which I regard as favorable news on the inflation front. And there’s been recent strength in housing starts, the leading economic indicators (ex-Katrina), and the level of unemployment claims.
As for Washington, while policymakers could be doing more to bolster a good economy, at least they’re not doing too much to damage it.
– David Malpass is the chief economist for Bear, Stearns.