by Calculated Risk on 11/12/2012 01:38:00 PM

It is always difficult to guess what policymakers will do!

On Friday I outlined the major components of the "fiscal cliff" and provided my initial guess at a compromise (actually more of a slope, hillock or bluff since Jan 1st is not a drop dead date). The components include expiring Bush tax cuts for high, middle and low income earners, the expiring 2% payroll tax cut, expiring Alternative Minimum Tax (AMT) relief, expiring emergency unemployment benefits, and scheduled defense spending cuts (aka "sequestration").

According to the updated CBO analysis, this fiscal tightening would cut the deficit in half, but would probably also lead to a new recession in 2013 (the CBO is forecasting unemployment would rise to 9.1% in Q4 2013).

My initial guess was a compromise would be reached and there will be no recession in 2013.  My guess is the compromise would include allowing the tax cuts for high income earners and the payroll tax cut to expire, however the tax cuts for low and middle income earners would be extended, the AMT relief would be extended, and the defense cuts would be scaled back.  Of course there are many more details.

My initial guess on timing was early in 2013. That was based on a two assumptions:
1) the tax cuts for high income earners would be allowed to expire, and
2) the GOP would not vote for any package that included a tax rate increase.

Since the tax cuts expire on Jan 1st, I figured the GOP could then vote for tax cuts for the middle class. But it is also possible that this agreement could be reached this year, and the bill could be written so there are no tax rate increases (since the tax increases will happen automatically, the bill doesn't have to include the increases).

So it is possible that some agreement will be reached this year.  My baseline forecast is that some agreement will be reached and that there will be some Federal fiscal tightening, but the tightening will not lead to a new recession.