Federal Reserve official: If Congress dawdles, economy will fall 3 percent

If Congress waits to resolve its differences over spending and taxes until next year, it could have a very unpleasant affect on the economy.

That’s the concern one of the Federal Reserve’s most prominent members, William Dudley, the president of the Federal Reserve Bank of New York.

In an appearance on CNBC and also in a speech before the Council on Foreign Relations on Thursday, Mr. Dudley warned that Congress could damage the economy if it cannot resolve its differences. If Congress cannot reach an agreement on extending the Bush-era tax cuts as well as cutting the budget, Dudley warns that a 3 percent contraction of gross domestic product would automatically begin on January 1.

“That would be a huge shock to an economy that isn’t that strong yet,” he warned in an interview with CNBC’s Steve Liesman.

Even the uncertainty of what Congress might do leading into year-end might be enough to cause economic damage, he warned. “Businesses might be more reluctant to hire, more reluctant to invest, because of uncertainty about how the fiscal cliff is going to be resolved,” he said. “So I think it’s a negative both now, in terms of uncertainty, and potentially later, because it could be resolved in a way that’s not good for the economy.”

Dudley’s warning followed a similar storm warning on Tuesday by the Congressional Budget Office which used the phrase “fiscal cliff” in describing the possibility of both taxes going up and fiscal spending coming down. The CBO went one step further saying the economy would slip into a recession in the first half of 2013 if Congress does not act.

Working against any agreement is the presidential race. In a forthcoming issue of Time magazine, presumptive GOP presidential nominee Mitt Romney said that he did not want President Obama and Congress to deal with the issues in a lame-duck session.

“You would like them to defer to you?” asked Time correspondent Mark Halperin. Replied Romney: “Absolutely…. My hope is to be able to come into office with people on both sides of the aisle who are cognizant of the critical nature of what America faces fiscally, what the people of America are facing employment-wise, the failure in our economy that is hurting so many people, and that we’ll see Republicans and Democrats say, OK, well what kind of tax proposals will encourage economic growth? What kind of regulatory reform will encourage economic growth?”

However, if Congress waits, as Romney is asking, the Internal Revenue Service will be unsure of what income tax withholding rates to publish for 2013. Corporate boards won’t know the tax rates for dividends.

“They need to get this done by the end of September or early October,” warns Pete Davis of Davis Capital Investments, a former economist on the Joint Committee on Taxation, who now advises Wall Street clients.

Mr. Davis says technically the US Treasury can decree that the IRS use a lower withholding rate in anticipation that the issue will get resolved later.  He recalls in 1992, President George H.W. Bush decreed lower withholding rates without any action from Congress to stimulate the economy.  “He put out a pretty good tax cut without any change in the law,” he says.

Davis thinks the warnings from the CBO and the Federal Reserve officials may be starting to have an effect. “Now some people are asking if there is some way to wiggle out of this and avoid the damage,” he says.

However, Congress has to be careful how it does this, he points out. If it does not pay for tax cuts or ignores its own sequestration rules, it risks having the rating agencies downgrade the US credit rating. In August of 2011 after Standard and Poor’s downgraded the US debt from AAA to AA, the Dow Jones Industrial Average sank almost 530 points.

So what is Congress to do? At the Council on Foreign Relations, Dudley said that Congress needs to start with a modest goal of reducing the deficit and then increase the reductions in later years as the economy improves. In addition, he says, any budget deal needs to be credible with bipartisan support so it can be sustained over many years.

If nothing gets done by Congress, Dudley says it could affect monetary policy. “It would have implications for the economic outlook, we would have to take that into consideration,” he said.