Research Notes: Fiscal Drag and Upward Revisions to Q2 GDP

Some brief excerpts from two research notes released this week. The fiscal drag is hitting hard right now and is expected to fade towards the end of the year. Right now it looks like Q2 is tracking close to 2% GDP growth.

From economist Alec Phillips at Goldman Sachs:

Earlier this year, we expected fiscal policy to weigh on growth most heavily in Q2 and Q3, when sequestration, other federal spending reductions, and the recent tax increases looked likely to have their greatest combined effect. It now looks like the fiscal drag will be somewhat more spread out than we anticipated.

The main reason is the 15% (annualized) drop in federal spending in Q4, followed by the 8% drop in Q1. This reduces the amount of fiscal drag from federal spending cuts we think is still in the pipeline, though it doesn't eliminate it. The chart below shows the drag on growth ...

Click on graph for larger image.

The upshot is that the amount of fiscal drag we expect is fairly similar in Q1, Q2, and Q3. This is consistent with our current growth forecast: we expect Q1 GDP to come in slightly lower than the 2.5% advance reading, at 2.3%, while we see Q2 tracking at 2.1% and we forecast growth in Q3 of 2.0%. In Q4, when we expect the drag from fiscal policy to fade somewhat, we expect real GDP growth to pick up to 2.5% at an annual rate.

From Ethan Harris at Merrill Lynch:

Despite significant fiscal tightening, the US economy continues to grow at a trendlike pace. Last fall we had expected growth to be weak in both 1Q and 2Q. As the better data came in, we assumed the shock was hitting with longer lags and we moved the “soft patch” to 2Q and 3Q. We argued that investors should look at two indicators for signs of weakness: soft retail sales and rising jobless claims. Instead, the “control” measure of retail sales continues to grow at about a 4% annualized pace and claims have fallen.

This week we are “marking to market” our 2Q forecast: we now see growth of 1.8%, up from 1.3% and roughly in line with the consensus. We have not changed our forecast for coming quarters. The economy has shown a lot more resilience than we had thought, but the full impact of the fiscal shock has not arrived yet and some kind of soft patch still appears likely.