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2012 Annual Report

Fiscal Policy Uncertainty
Pivoted on the Actions
of Congress

U.S. fiscal policy uncertainty put a damper on economic growth. Meanwhile, state and local government finances improved somewhat, driven by an improving economy and improved housing market. Some states began to tackle the longer-term problem of underfunded public pensions.

Lack of clarity about the future course of U.S. fiscal policy kept many businesses and consumers on the sidelines in 2012. This decision paralysis weighed heavily on economic activity and proved a barrier to more robust growth and job creation.

Fiscal policy does not fall within the central bank's purview, and Federal Reserve officials typically refrain from commenting on such matters (see the sidebar). But as the headwinds to economic growth became apparent, Fed policymakers voiced their concerns about the negative impact of fiscal policy uncertainty on the fragile economic recovery. Economic intelligence gathered from the Atlanta Fed's business contacts in 2012 echoed those sentiments. For instance, the August edition of the Atlanta Fed online newsletter Southeastern Insights noted that "limited visibility is resulting in a reduction or postponement in capital investment and hiring plans for several very large businesses that represent most sectors of the economy." Further, fiscal uncertainty surrounding future tax rates and the fiscal cliff at the end of 2012 clouded the forecasting abilities of southeastern firms, the report noted. These effects are not limited to firms in the Southeast.

Monetary versus Fiscal Policy

Fiscal policy and monetary policy were frequently in the 2012 headlines. Both types of policy can affect the economy's short-run performance, but they are quite different and are conducted independently by separate government entities.

As the central bank of the United States, the Federal Reserve is solely responsible for conducting monetary policy. Simply put, monetary policy describes the central bank's actions to influence the volume and price of money and credit in the economy. The Fed conducts monetary policy in support of two objectives set forth by Congress—price stability and maximum employment.

The Federal Open Market Committee (FOMC) has traditionally conducted monetary policy by adjusting the target for the federal funds rate—the interest rate on overnight loans between banks. The committee can lower the target rate to make monetary policy more accommodative. Conversely, raising the federal funds rate tightens policy. That rate has been near zero since late 2008. The FOMC could not lower it any further, so it has used some unconventional tools, including large-scale asset purchases (LSAP) , to influence longer-term interest rates and key asset prices.

The Fed's monetary policy decisions are insulated from short-term political pressures. Indeed, monetary policy independence is a key characteristic of modern central banks—one that empirical studies have shown brings about better outcomes for price stability.

Fiscal policy, on the other hand, generally describes the taxation and spending decisions made by the federal government—namely Congress and the presidential administration. For instance, when Congress votes to increase taxes or approves an increase in spending, it is conducting fiscal policy. By affecting aggregate demand, those decisions can boost or dampen economic growth in the short run. Stimulative fiscal policy includes tax cuts and spending increases, such as those put in place during the 2007–09 recession. Tax increases and spending cuts, in contrast, tighten fiscal policy.


Fiscal cliff a significant source of uncertainty

In his July 2012 monetary policy report to Congress, Fed Chairman Ben Bernanke identified the U.S. fiscal situation as a primary source of risk to economic growth. The chairman warned that sudden tax increases and spending cuts would likely thwart the fragile recovery while still recognizing the need to put the country's fiscal matters on a more sustainable longer-term path. Atlanta Fed President Dennis Lockhart also weighed in during a November speech, warning that monetary policy would not be able to counteract the damage to the economy that going over the cliff would cause. Indeed, a widely cited report by the Congressional Budget Office (CBO) offered this sobering assessment: failure to avert the cliff would send the U.S. economy into a mild recession and dampen job creation by roughly 1.25 million jobs.

State of the states

While federal fiscal matters weighed heavily on the U.S. economy in 2012, the budget situation for state and local governments improved somewhat. (See the video for a discussion of state and local government finances.) Revenues were helped along by improvements in the broader economy, the employment situation, and housing markets. Forty-four states reported year-over-year growth in revenues for the 2012 fiscal year, according to a report by the National Conference of State Legislatures. Despite rebounding to prerecession levels, state revenues remained sluggish. "The year 2012 looked like the start of a slow-growth era for state governments," said Chris Cunningham, a research economist and assistant policy advisor in the Atlanta Fed's research department. Income taxes accounted for much of the rebound, although sales tax revenues also improved, he noted.

Meanwhile, municipal government budgets experienced a bit of relief as property taxes—their biggest source of revenue—stopped declining later in the year. Property assessments are not expected to rebound quickly. More generally, the story for local governments in 2012 "was mostly about what didn't happen," Cunningham said. Notably, the feared wave of municipal bankruptcies failed to materialize despite a few high-profile bankruptcy filings.

Even so, the fiscal situation in 2012 for state and local governments remained vulnerable. Unemployment rates remained elevated across much of the nation, which constrained tax revenues and increased demand for government services. States and municipalities also grappled with the uncertainty stemming from federal fiscal policy, new health care laws, and the overall economic outlook.

State and local governments tackle "the other debt problem"

Several states and municipalities made efforts in 2012 to deal with the longer-term risks posed by underfunded public pensions. Although not an immediate threat, the severely underfunded state of many public pension systems represents a potential source of financial instability.

Public pensions in the United States provide retirement benefits for roughly 23 million current and retired public employees and control between $2.5 trillion and $3 trillion in assets (see chart 1). The funding ratio, or the difference between the market value of the pension's assets and the present value of the benefits promised to employees and retirees, declined significantly during the recent financial crisis and subsequent recession (see chart 2). Many public pension systems suffered dramatic losses in their asset portfolios beginning with the financial crisis, but promised liabilities did not decline.

With interest rates expected to remain low for some time, no one was forecasting a quick return to healthier funding ratios. (Depending on the assumed rate of return on assets, public pensions in 2011 faced a funding gap that ranged from $800 billion on the low end to $3 trillion to $4 trillion on the high end.) Fund sponsors generally have three options to remedy funding gaps, explained Paula Tkac, a vice president and senior economist in the Atlanta Fed's research department. They can step up contributions (either from taxpayers or employees, or both), decrease future promised benefits to new employees, or shift their portfolios toward riskier, higher-return assets. The promised benefits to current employees and retirees are difficult to reduce because they carry legal protections that vary by state. Some state and municipal governments began to take action on the politically difficult task of reforming their pension systems. Louisiana, New Jersey, and Tennessee, for example, took initial steps in 2012 to reform their pensions.

Public pensions did not pose an immediate risk to the U.S. economy or financial system, but they were headed down an unsustainable path in 2012. Further, the market discipline imposed by bond markets can make this longer-term problem more pressing, Tkac noted. The Federal Reserve, as one of the agencies charged with monitoring potential sources of financial instability, has made efforts in recent years to evaluate and more deeply understand how public pensions and their roughly $3 trillion in assets are integrated into financial markets.