Posted on June 6, 2012

Briefing from Washington

 Discussions were deep and broad as we received briefings on the regulatory, tax and legislative policy developments.

Most of the discussions, however, focussed on the global economy and macro policy. In preparation for a meeting with the Fed Board of Governors, we debated the outlook for the U.S. economy, the impact of the European debt crisis, the so-called ‘fiscal cliff’ and the likely policy reactions. We briefed the Board, answering questions they had submitted earlier, regarding the outlook, labour market, and Europe. Clearly, the Board remains concerned about the recent weakness in employment, although Bernanke has publicly suggested that it might be reflective of seasonal distortions from the mild winter. Some, such as Vice-Chair Janet Yellen, are not convinced and have called for additional easing. The Chairman’s testimony yesterday before the Joint Economic Committee of Congress disappointed markets as he seemed to suggest that no additional Fed easing—such as an extension of Operation Twist set to expire this month, larger mortgage-backed securities purchases or QE3—will be forthcoming at the June 19 and 20 FOMC meeting.

As Bernanke faced a relatively hostile Committee, it is not surprising that he did not call for QE3. Indeed, the vice-chair of the JEC—Kevin Brady (R-TX), senior member of the House Ways and Means Committee—openly urged Bernanke not to introduce QE3. The Economic Advisory Committee of the ABA was split regarding the likelihood of Fed action at the next FOMC meeting. Half of us, myself included, think that there will be no action taken by the Fed despite a likely more dovish press release, while the other half mostly expect an extension of Operation Twist or larger MBS purchases. They agreed that the impact of Operation Twist would largely be confidence building, given that long-term Treasury yields are already extremely low.

The Fed might prefer stepped up MBS buying to narrow the widening gap between mortgage rates and Treasury yields. Taking 30-year fixed rate mortgage yields down another 50 basis points to 3% was deemed by some to give a boost to the nascent recovery in housing. Clearly, however, the Fed is most concerned about the fiscal cliff and the instability in Europe. Bernanke urged Congress to take concerted action to avoid the devastating economic effects of the coinciding cuts in government spending and hikes in tax rates that are slated to occur at year-end. It is widely believed by political analysts that the Congress will do nothing in this regard before the election. The lame duck Congress will have less than two months to deal with the issue. Ken Clayton, EVP, Legislative Affairs and Chief Counsel of the ABA, characterized Congress as “a crisis-oriented institution that will act only in a crisis”. The most likely outcome is that Congress will ‘kick the can down the road’ for a few months (or longer, although this is unlikely).

The remaining uncertainty, it is broadly agreed, will dampen economic activity in the first quarter of next year. However, some argued it would diminish Q4 growth as well. Clayton suggested that the outcome of the presidential election is too close to call and that it will be determined primarily in eight key swing states: Virginia, Ohio, Iowa, Colorado, Florida, New Hampshire, Nevada and Wisconsin. The campaigns will micro target key districts in these states. On the Congressional side, he believes that the Republicans will likely keep the House, but with a narrower majority. What matters more is the Senate where the Democrats (including two Independents that vote with them) currently have a 53-to-47 majority.

There are key senatorial races that will be closely watched (such as Maine’s retiring Republican Senator Olympia Snow and the “closest race in the country” in Massachusetts between Scott Brown and Elizabeth Warren.) Clayton believes that a Republican majority in the Senate is a long shot; and, if so, would be a small majority, certainly not the 60 votes needed to get their way. Of course, the Vice President breaks a tie in the Senate, so how the White House goes is very important. As well, the White House sets the legislative agenda. The bottom line here is that neither party will have a large enough majority for the new president to ram through Reagan-style game-changing legislation in the critical ‘first hundred days’. In addition, the sentiment is that the extremes of both parties—the Tea Partiers and the Occupy Wall Street crowd—have peaked in their influence on the electorate or Congress. Another issue Washington is talking about is the impending Supreme Court decision (in the next two weeks) of the Constitutionality of ‘the individual mandate to buy health insurance’ in the Obama Care legislation. It will decide if the federal government can mandate universal coverage; and, if not, it will decide on the severability of this clause from the legislation. If it is severable, it goes back to Congress to make amendments. If it is not severable, Obama Care is dead. Analysts think, either way, this will have little impact on the election as Obama can blame the Supreme Court if health care legislation doesn’t go through. Who knows? On the European situation, the twelve economists were split on whether Greece would leave the Eurozone. My view is probably not and if they did, it would be in an orderly fashion many months or years from now.

The general view is that the EU would continue to muddle through, moving toward banking and fiscal unity at a glacial speed.

Bottom Line: Against this backdrop, the U.S. economy will grow at a moderate pace of about 2.2% this year and next with the unemployment rate falling only slightly. The election battle will be tough to the bitter end and Congress will remain dysfunctional even after the election given that neither party is likely to have a clear-cut majority.