Tax Cuts + QE2 = Stimulus 2.0 and More Points to GDP

With President Obama and Congressional Republicans reaching a compromise on the Bush Tax Cuts, unemployment benefits and a payroll tax holiday the Federal Reserve Bank gets its much needed congressional aid in the battle against a double-dip recession and deflation.  The impact of this extra stimulus will go a long way towards easing psychological concerns about the state of the economy, and according to economists at Goldman Sachs (NYSE:GS) it will add between 0.5 to 1% to 2011 GDP.  Such a deal seemed nearly impossible several months ago but today is reality.

Much has been made of Ben Bernanke’s 60 Minutes interview in which he professed a willingness to embark on future quantitative easing should circumstances necessitate it.  As always, the talking heads take this to the extreme in labeling QE3 inevitably on the table.  Meanwhile just last week two Fed officials indicated that the $600 billion was just a rough guideline that would be monitored and could be adjusted as time went on.  These officials indicated that it is very possible that the Fed’s QE2 initiative could fall short of the $600 billion target should inflation pick up quicker than anticipated.

When you combine the message from Bernanke and the rest of the Fed board since the QE2 announcement, it becomes clear that in the event of further deflationary concerns the Fed will continue easing as needed; however, should inflation rear its ugly head then the Fed will pare back easing.  In other words, the message from the Fed is ultimately not much different than how our central bank manages interest rates in normal times.  Think of QE as interest rates in a liquidity trap environment.

All that being said, the message from the Fed and prominent market participants reflected the view that QE on its own would have limited impact.  It would be necessary to couple QE with some sort of fiscal stimulus in order to take the most effective path back to a sustainable and more robust recovery.  When Bill Gross wrote his popular Run, Turkey Run investment outlook and labeled QE as analogous to ponzi-scheming, a core component of his critique was that Ben Bernanke can’t do it alone and policymakers were acting more like a posturing waste of space than a constructive force in restoring the economy to its full potential.  As Gross said, “Ben Bernanke, however, will try – it is, to be honest, all he can do. He can’t raise or lower taxes, he can’t direct a fiscal thrust of infrastructure spending….”

The fact that the deal to extend the Bush Tax Cuts was coupled with a semi-strong stimulus package makes the economic outlook increasingly more optimistic.  Not only does the new round of fiscal stimulus (yes it is stimulus, that label should not be viewed as contagiously as it is) help in and of itself, this stimulus also serves to reinforce the prospects of success for QE2.  Now market participants have raised their inflation expectations AND the government has taken tangible steps to encourage spending and investment from the middle class.

Granted infrastructure spending would have been a far better initiative.  Many view infrastructure spending the wrong way.  In fact, the very fact that “spending” juts its way into the title is indicative in and of itself as to how wrong such infrastructure investments are viewed.  Spending implies a cost that is merely spent and gone, while investments implies the building of some sort of equity on the other side of the equation.  When our government puts money into public works projects and infrastructure, that money doesn’t vanish into midair, we get an asset that generates income in a broader sense.

Regardless, at this point in time our policymakers extracted the maximum amount of stimulus that is politically stomachable at present to get the economy on its feet.  Bernanke is assuredly feeling better with himself over at the Fed knowing that there will be more help coming from the Beltway in his quest to fight the greatest credit crunch to hit this country since the Great Depression.  The fact that Goldman economists project this act alone to add 0.5 to 1% to GDP growth is significant, especially in light of the fact that just last week Goldman economists upgraded their growth forecast for the economy BEFORE this new stimulus appeared evident.

Check Out: Goldman’s Target On Every Key Market For 2011 >>