Fiscal stimulus – complement not substitute to Fed easing

Plagued by an iffy labor market, contracting manufacturing activity and plummeting house prices, neither the Democrats nor the Republicans would have wanted to face the wrath of voters by standing in the way of expansionary fiscal policy measures, when the monetary authorities have gone aggressive with a 75 bps inter-meeting cut. Bearing in mind the high cost of inaction, the White House and the Congressional leaders quickly hammered out a fiscal stimulus plan with nearly USD 150 bn of tax relief aimed to bolster the ailing U.S. economy. The package valued at "about 1% of GDP", as expressed by President Bush, now awaits final approval from the Senate and sign off from the President before being implemented.

The House plans to vote the bill in early February and send it to President Bush by February 15. As of now, I do not envisage much problem on this front. The speed with which negotiations have been concluded between the two parties, underscores the urgency of the situation. Moreover, the bill is largely along expected lines and is unlikely to lead to heated debates.

Tax credits amounting to USD 100 bn form the key part of the proposal. Around 117 mn U.S. households are expected to receive tax rebates of up to USD 1,200 with checks to low-income and middle-class workers, including those who pay payroll taxes but not income taxes. Thus only the retirees, around 27 mn in number, would be receiving no tax rebates.

Highlights of the proposed package are as follows:

Tax rebates and incentives to stimulate consumption spending

• Most income tax payers to receive USD 600; working couples USD 1,200
• Workers who earn at least USD 3,000 but don’t pay taxes, to receive checks of USD 300-600
• People under both categories to get an extra USD 300 per child
• Rebates would be phased out for those families earning more than USD150,000
• No rebates for those earning more than USD 174,000, unless they have children
  

Housing Related

• Dollar limit on mortgages that can be bought by Fannie Mae and Freddie Mac to be raised above USD 600,000 and perhaps as high as USD 730,000, from the current limit of USD 417,000
  

Business tax write-offs

• Additional 50% write-off on capital-equipment investments made this year
• Small businesses to be able to write off USD 250,000 from their taxes, up from USD 125,000
  

In formulating the bill, both the parties were forced to cede ground. The stimulus bill excluded two stimulus measures proposed by the Democrats, namely, expanding food stamps or lengthening benefits for unemployed workers. The bill also does not extend the 2001 and 2003 tax cuts beyond their scheduled expiration in 2011, a proposal strongly supported by the Republicans.

The proposed fiscal plan reverberates the one laid out during the last U.S. recession that trailed the 2001 dotcom bubble. The 2001 stimulus plan was largely regarded as being well timed and effective in keeping the recession mild. Reacting to the impact of the 2001 fiscal package, the chairman had earlier said, "My judgment, and I think the judgment of most of the empirical analyses that have been done, was that the rebates in 2001 did have some impact on spending and that was of some assistance in keeping the 2001 recession relatively moderate." The then government had mailed a total of USD 38 bn (comprising of USD 300 and USD 600 of one time rebate checks) to one third of US households. Although these rebate checks did prop up consumer spending to a certain extent, according to studies by the U.S. Labor Department, its role in reviving the US economy, especially in stimulating business investments has been seen to be limited. According to some Republicans, similar tax breaks to businesses had added around 100,000 more jobs to the economy in 2003. However, in the current scenario, when demand continues to remain subdued, direct subsidies to business investments are unlikely to have the desired impact on investments unless sales get a boost from higher consumer spending.

The question that now arises is whether the fiscal package would do away with the need for aggressive rate cuts. While this is an interesting possibility, I would like to indicate that even in the most optimistic scenario, the package is unlikely to be effective before mid 2008; as the first tax rebate checks are expected to reach the US households only between May and July of this year. With the US economy on the brink of a recession, it is unlikely that Bernanke will be able to hold out for that long. Hence, I would stick on to my expectations of another 100 bps cut from the Fed by the end of Q1-08, which would bring the Fed rate to 2.50%.