Wall Street on Wednesday celebrated Congress' vote to prevent sharp tax increases from hitting the economy and causing a recession this year, with the Dow Jones industrial average surging by 308 points. But economic gurus warned that the deal falls short of solving the nation's huge debt problems.
The House late Tuesday night gave final approval to a bipartisan compromise that raises taxes by $650 billion over the next 10 years primarily by allowing tax rates on the wealthy to revert to 1990s levels. Economists said the measure likely will slow economic growth this year but not plunge the economy into a recession, avoiding the dire outcome of originally scheduled tax increases.
"We have managed to avert some of the 'fiscal cliff.' It's time to celebrate," said Leon LaBrecque, chief strategist at LJPR, an investment management company, expressing the relief of many on Wall Street who had been dreading the arrival of the Jan. 1 deadline for months.
"The deal is done" after a half-year of uncertainty that plagued the markets and hung over the economy in 2012, said Gary Thayer, chief macro-strategist at Wells Fargo Advisors. "This compromise will not solve the longer-term debt and deficit problems facing the United States" because it does not include major spending cuts or entitlement reforms, he said. "But it will prevent major tax increases on most Americans, and will, therefore, likely keep the economy from falling into recession."
By putting off for two months across-the-board cuts in discretionary spending that had been scheduled to go into effect Tuesday, the deal forged by Vice President Joseph R. Biden and Senate Minority Leader Mitch McConnell, Kentucky Republican, sets up a new deadline of March 1 for negotiating spending cuts and entitlement reforms needed to control the deficit over the long term. The nation's $16 trillion debt limit also will have to be raised in that time, providing further pressure for a deal and another vehicle for enacting budget reforms.
"The impact of all of this should be to slow the U.S. economy in the first half of 2013, but not put it into recession," said David Kelly, chief global strategist at J.P. Morgan Funds.
While a fight still looms over spending reforms and carries uncertainties for businesses and the economy, Mr. Kelly said the biggest impact on the economy this year most likely will come from the Jan. 1 expiration of President Obama's 2 percentage point payroll-tax cut, raising taxes by an estimated $100 billion on taxpayers at all income levels.
"That is where the impact is likely to be greatest — consumer spending on basic goods and services like groceries, clothing, restaurant meals and gasoline should all take a hit over the next few months due to lower take-home pay," he said.
But for the time being, investors were relieved that Congress acted to avoid the very worst. In the most powerful rally on Wall Street in more than a year, the Dow ended up 308 points at 13,413, a gain of more than 2 percent that brought it within reach of a five-year high. The Standard & Poor's 500 index and other major stock indexes also rose more than 2 percent, as did major indexes in Europe and Asia overnight.
Mark Zandi, chief economist at Moody's, said the deal prevents major damage at a time when economic growth was otherwise poised to accelerate from last year's 2 percent rate. He estimates that the tax increases taking effect this week will keep growth at about 2 percent this year and lead to the creation of 600,000 fewer jobs.
But Mr. Zandi was concerned about a further potential dampening effect on economic growth as Congress and the White House continue to wrangle over spending and the debt limit ahead of the March 1 deadline.
"This means more political brinkmanship this year, with uncertain consequences for business, consumer and investor confidence," he said. The stock market and consumer and business confidence already took major plunges in December because of the political fight over the fiscal cliff.
Mr. Zandi was one of many analysts who pointed out that while Congress prevented the worst from happening Tuesday, it did not resolve the government's overarching debt and deficit problems that threaten the economy over the long term.
"Perhaps the deal's biggest shortcoming was its failure to bring the federal government closer to fiscal sustainability," Mr. Zandi said. "My guess is that this current round of bargaining will reduce the federal deficit by $1.6 trillion over 10 years — about half as much as needed to stabilize the nation's debt-to-GDP ratio later in this decade."
The International Monetary Fund made the same point Wednesday, saying the measure did not go far enough to prevent an eventual sovereign debt crisis like the one in Europe.
"More remains to be done to put U.S. public finances back on a sustainable path without harming the still-fragile recovery," IMF spokesman Gerry Rice said.
"This bill does nothing to address the long-term budget problems facing the U.S.," said Tom Porcelli, an economist at RBC Capital Markets, noting that the deal included none of the reforms in entitlements, such as Social Security, Medicare and Medicaid, sought by Republicans.
"The fact that Republicans were willing to take a deal with no net spending reductions suggests to us that this group will now push hard for spending cuts in the upcoming showdown on the debt ceiling," he said. "So while the market breathed a big sigh of relief in the aftermath of the cliff deal, increased contentiousness in D.C. could soon take the bloom off the rose."
But J.P. Morgan's Mr. Kelly said Congress and the White House should get credit for at least eating away at the deficit problem, especially when the tax increases are combined with $1 trillion in across-the-board spending cuts that remain in law even though they were postponed until March 1.
He estimates that the combined anti-deficit measures will reduce the budget deficit from a high of 10 percent of economic output in 2009 to 4.2 percent by 2014 — not far above the 4 percent level at which debt payments stop escalating and start to stabilize, he said.
"This tax increase will make a big dent in the deficit, assuming that some other spending cuts more or less replace the much-hated sequester," he said.
Wall Street agencies, which have warned that they will downgrade U.S. credit ratings this year unless Congress enacts measures that stabilize the debt, were mostly quiet Wednesday. Only Standard & Poor's Corp., which has already withdrawn the nation's top AAA rating, commented that the deal does little to change the credit outlook even as it improves prospects for the economy this year.
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