Hedging Tax Hikes Distorts Income, but Suppresses Spending

Personal disposable income growth jumped 2.8% in December, more than twice the increase in November. All of that acceleration may be attributed to special dividends and early bonuses that were released to top income earners by their employers as a way to avoid higher income taxes associated with the fiscal cliff negotiations. Indeed, personal disposable income growth actually decelerated in December if that hedging that we saw at the end of 2012 is excluded. The only category of income to rise more rapidly in December than in November was transfer payments (government benefits like Social Security), not exactly where we would like to see the strength concentrated.

The stage is now set for a much larger drop in incomes in January as payback to the hedging in late 2012 and higher tax rates across the board. The expiration of the payroll tax holiday was particularly large and shocking to many.

Personal consumption expenditures rose a much more modest 0.2% during the month, less than a third of November’s pace. Almost all of that gain was concentrated in vehicle sales, which were bolstered by insurance payments and replacement demand following Superstorm Sandy. Spending on services was particularly weak. This is a pattern that we saw earlier in the year, particularly as households held off on going to the doctor and cut back on optional medical procedures. We have yet to see where exactly the weakness was concentrated in December.

The savings rate surged to 6.5% in December from 4.1% in November. Much like the jump in income, however, this increase will be reversed and more in January.

Separately, the price index for personal consumption expenditures (PCE, the Federal Reserve’s preferred measure of inflation) decreased less than 0.1% in December, after falling 0.2% in November.  On a year-over-year basis, the PCE price index rose 1.3%, well below the Fed’s target of 2% over the medium term.

Bottom Line: Fears regarding the fiscal cliff appear to have played a larger role in curtailing spending in December than initial retail sales reports suggested. This provides validation to retailers who claimed they never really regained some of the ground lost after Superstorm Sandy. Moreover, tax hikes and uncertainty over fiscal policy are likely to further suppress consumer spending at the start of the year. The only offset is the replacement demand and repairs associated with Sandy, which are not insignificant.

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One Comment

  1. Diane Swonk
    Posted January 31, 2013 at 9:19 am | Permalink

    I just received a question that is very topical and likely to interest other readers:

    “What happens if Q1 of 2013 GDP shrinks? Does that mean we are in a recession irrespective of why Q4 of 2012 contracted (because of government spending or lack thereof) ?”

    My reply:

    No. It does not. Recession is loosely defined as two consecutive, negative quarters but the reason for the decline matters. The National Bureau of Economic Research (NBER) is the official arbiter of the timing of recessions and includes a myriad of variables, the most important of which is employment. Currently, employment is still rising.

    You could, however, get into a phase where the economy is in what we call a “growth recession.” That is when growth is too weak to absorb the number of workers entering the labor force, causing unemployment to rise.

    Risks of real and painful recession are still much higher than we would like to see, given the ongoing uncertainty regarding fiscal policy. The consensus is fairly strong that we will suffer some portion of a sequestration, starting March 1. That would include more than $100 billion in draconian spending cuts, designed to be so painful that Congress would compromise rather than allow them to occur. Critical defense and health care spending would be hit hardest.

    The magnitude of the cuts, together with tax hikes, could easily reduce the economy to a stall speed in the first quarter. The additional blow to confidence in elected officials, added to uncertainty created by such a showdown over spending, could cause more hesitation and precipitate a recession.

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