Remember the Sequester? It’s Finally Dinging the Economy

When the federal spending cuts known as the sequester went into effect March 1, President Obama and many others predicted the economy would tank. It didn’t. Consumers remained surprisingly willing to spend. Employers continued to hire. The stock market hit several new highs.

It's now beginning to appear, however, that the sequester is more of a slow-release drag on the economy than the fast-acting depressant some economists predicted. Job growth has slowed again, as it has during a “spring swoon” that occurred during each of the past three years. Forecasters have been reducing their expectations for second-quarter GDP growth. And investors who were ebullient just a couple weeks ago are now back to their usual skittish selves.

Every loss must be felt

The sequester was never likely to be catastrophic, since it amounts to less than $100 billion in annual spending cuts in a $16 trillion economy — less than half a percentage point of total economic activity. But every loss in economic activity has to be felt somewhere, and combined with tax cuts that went into effect at the start of the year, the sequester is certainly big enough to slow things down.

And it is doing that, finally. Forecasting firm MacroEconomic Advisers has lowered its second-quarter forecast for GDP growth from 1.8% to 1.3%. That’s very weak growth that will probably hold back hiring and spending, and depress confidence. “The sequester is expected to slow growth this year, and largely accounts for the weak second-quarter growth and lackluster third-quarter growth,” the firm said in a recent report.

Pullbacks in the job market seem likely during the next few months. After five straight months of improvements, small businesses surveyed by the National Federation for Independent Business curtailed hiring in May. The latest jobs report from ADP showed private-sector firms created about 30,000 fewer jobs than expected in May, with companies hiring at a pace too slow to bring down the unemployment rate. Manufacturing activity, which is directly affected by federal spending on defense contractors, has fallen below the level generally considered to be recessionary.

Tony Nash of forecasting firm IHS warned recently on CNBC that the effects of the sequester should build as the year goes on. Even the Federal Reserve mentioned the sequester in its latest "beige book" report on regional economic conditions, citing concerns about defense-industry cutbacks in the Cleveland and Richmond regions.

Economic indicators rise and fall all the time, of course, so it’s foolish to read too much into any one batch of numbers. But if further signs of "sequestritis" hit the economy, it could have an outsized impact on the stock market and on other factors likely to impact key business decisions for the rest of 2013.

The big question

The biggest question is whether government austerity measures will depress the official job numbers released by the Labor Dept. over the next several months. The surprise so far this year is that the private sector has held up better than expected, more than offsetting cuts in government payrolls and helping the unemployment rate inch down to 7.5%. At some point, however, the sequester cuts could cause much larger government cutbacks or bleed into private sector hiring, pushing the unemployment rate back up.

That matters a lot more than usual because employment is the largest factor affecting the Federal Reserve’s aggressive monetary stimulus policies. Stocks have tumbled lately, partly because of concern that a strong job market will lead the Fed to begin dialing back its loose-money policies — which have given a big lift to stock prices — sooner than the Fed has suggested. If there’s a sudden downturn in hiring, however, it would give the Fed more reason to keep the spigot open, which would presumably boost stocks.

Most economists think the recovery will pick up steam starting in 2014, when it has fully adjusted to Washington’s austerity measures. It could be bumpy for the rest of this year, however. “The economy is still not strong enough to warrant a cutback in Fed policy,” economist Joel Naroff wrote to clients recently. “Washington has not helped, as the sequestration is reducing government spending, and the tax increases have strained household finances.”

If the sequester does cause a slowdown in hiring and spending, it might be the sort of pause that refreshes. Consumers have maintained their spending amid tax increases not because their incomes have risen but because they’ve been saving less. Taking fewer trips to the mall and putting a bit more in the bank might strengthen their finances. And more clarity about factors affecting Fed policies — such as whether or not the sequester will harm the economy this year — ought to reduce stock-market jitters. The sequester itself may end up being less harmful than all the confusion it has caused.