Why the Economy Will Take Off—in 2013

The "fiscal cliff" will depress the economy for the rest of 2012--but next year looks rosier.

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As long as unemployment is above 6.5 percent and inflation is stays below 2.5 percent, the Federal Reserve suggested it will keep interest rates near zero.

Forget about 2012.

Economists at the Federal Reserve, Wall Street banks, and top forecasting firms mostly agree that for the rest of the year, the economy will bumble along with the same torpor it's exhibiting right now. With the November elections and the "fiscal cliff" that Congress needs to deal with by the end of the year filling the horizon with uncertainty, anybody who can put off a big decision is.

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But next year might bring a much better story. While hiring this year has slowed to almost nothing, there are some signs that businesses are preparing to start expanding payrolls more aggressively. The housing market is finally turning a corner, with virtually no help from Washington. And if policymakers can resolve a few huge issues, businesses may stop worrying about an economic crisis manufactured in Washington, and start spending more freely.

The implications for the presidential campaign are momentous. President Obama needs to convince voters that the economy is unambiguously improving, while Mitt Romney and his fellow Republicans will benefit from widespread distrust of Obama's economic policies. It's plausible that congressional Republicans might even work to undermine economic confidence, though of course that could backfire if it appears too deliberate.

Consumer confidence, nonetheless, is eroding as the elections draw closer. During the first three months of 2012, employers added about 225,000 jobs per month. During the next three months, that fell to just 75,000 jobs per month, a weak hiring pace that could easily continue till November. The stock market has been in a slump and corporate earnings seem poised to disappoint investors, after several years of strong growth.

[See why the outlook for the economy on Election Day is bleak.]

But there's some good news buried beneath the gloomy headline numbers. While hiring is weak, layoffs are also at low levels, according to placement firm Challenger, Gray and Christmas. That suggests companies don't want to get any smaller, perhaps because they anticipate better days ahead. It's easier to slash payrolls than to staff up quickly, and a lot of companies know they can't cut much more without compromising service or quality. Another key indicator, the number of workers filing claims for unemployment insurance, has been drifting down as well, suggesting that employment has stabilized and could move upward before long.

The housing market remains deeply damaged, with millions of homeowners likely to remain underwater on their mortgages for years. But prices seem to be bottoming out in many markets, six years after the housing bust began. That's critical because buyers aren't likely to materialize en masse until they're convinced that home values aren't likely to fall any further. A housing revival will probably be very gradual, but it will still turn the sector from a drag on economic growth to a contributor.

[See Why Obama's tax plan will pass--even if he loses in November.]

There are two other big factors depressing the economy right now: the European debt crisis and the last-minute decisions Congress must make at the end of the year on tax hikes and spending cuts due to go into effect in 2013. There's been a bit of progress in Europe as policymakers slowly roll out solutions that might help rescue troubled banks while also dealing with the onerous debt levels of overextended nations like Greece, Spain, and Italy. The pace of progress has been maddeningly slow, but every half-measure that buys time does help shave the magnitude of the problem, a little.

That leaves the fiscal cliff as perhaps the single-biggest obstacle to a buoyant recovery. There's virtually no chance of meaningful action before November, but there's also loud whispering, among both parties, about the need for Congress to get its act together and stop holding the economy hostage.

Once it's clear who will control the White House and both houses of Congress in 2013, furious negotiations will start. There are many permutations of what a deal might ultimately look like, but in general, there's a good chance that tax hikes scheduled to go into effect in 2013 will be delayed, and spending cuts will be watered down. Then, next January or February will come a fresh fight over increasing the government's borrowing limit, raising the spectre of another man-made disaster similar to what happened with the debt-ceiling debacle last summer, which led to the first-ever downgrade of the U.S. credit rating.

If politicians can handle that better next time, the first quarter of 2013 might end with a lot of urgent policy questions resolved, at least temporarily. Congress will probably be taking up longer-term efforts to reform the unwieldy tax code, pare huge entitlement programs like Medicare to more affordable levels, and get the national debt under control.

All of that could entail political warfare that lasts for years. But if business leaders and consumers sense a break in the hostilities, they may very well tune out the politicians for a while and start spending again. It won't come a moment too soon.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.