Surprise decline in GDP fails to shift debate over ending sequestration

A sharp decline in defense spending led the U.S. economy to contract at the end of 2012 by 0.1 percent, but it did little to change the fight over further cuts to the Pentagon set to begin in March.

The White House used the report to lash out at Republicans, arguing the GOP should agree to a deficit-reduction package that includes spending cuts and tax hikes to replace the $85 billion in scheduled cuts known as sequestration.

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“Our economy is facing a major headwinds, and that's Republicans in Congress,” White House press secretary Jay Carney said. “It can't be 'we'll let sequester kick in because we insist tax loopholes remain in place for corporate jet-owners.' ”

Republicans counter that they agreed to raise tax rates on households with annual income above $450,000 in a deal earlier this month and that they will not raise taxes again. Instead, they say President Obama must accept spending cuts.

If the White House will not agree to trim entitlement benefits and cut spending, they see sequestration — which both parties initially viewed as something to avoid at all costs — as a best-case scenario.

“These arbitrary, automatic cuts were a creation and demand of the White House in 2011,” Brendan Buck, a spokesman for Speaker John Boehner (R-Ohio), said in a statement. “Twice the House has passed legislation to replace them with common sense cuts and reforms. If there was any uncertainty late last year about the sequester, it was because the Democratic-controlled Senate, per usual, never lifted a finger to pass a plan to replace it.”

There was little sign that the bad economic news would convince either side to take action to prevent sequestration.

House Majority Whip Kevin McCarthy (R-Calif.) said the report on GDP was a “stark example of how political games in Washington have real consequences,” while House Minority Leader Nancy Pelosi (D-Calif.) blamed the “looming sequester” for contracting growth throughout the economy.

She put all of the blame on Republicans, saying their strategy of “obstructionism and manufactured crises” had led to uncertainty.

Sen. Marco Rubio (R-Fla.) said the contracting economy highlighted Obama’s economic failures.

“The president and his allies need to give up their obsession with raising taxes and join Republicans in pursuing real economic growth policies through tax, regulatory and energy reform,” he said in a statement.

Stocks declined Monday as the surprising drop in GDP led to new worries that Washington might stand in the way of economy recovery.

A day before the GDP report, a private-sector measure of consumer confidence fell to its lowest level in over a year in January as consumers absorbed the end of a two-year payroll tax cut and higher tax rates imposed on wealthier households.

Analysts with the Conference Board, which produces the confidence index, said consumers had lost some hope in the economy’s future.

Facing the increasingly grim data, the Federal Reserve, at its regularly scheduled policy meeting, opted to hold steady. The Fed announced Wednesday it would continue buying billions of dollars worth of bonds each month and keeping interest rates as low as possible in an effort to support an economic recovery.

Declining government spending puts more pressure on a slowly recovering private sector to take up the slack, and it highlights the extent to which the Fed is propping up the economy.

Real federal government expenditures and investment fell 15 percent in the fourth quarter, compared to a 9.5 percent increase in the third. And national defense spending tumbled 22.2 percent, compared to a 12.9 percent boost in the third quarter.

Defense spending typically spikes in the third quarter and lags in the fourth, but the swing in 2012 was extreme. The drop in defense spending was the largest in 40 years and, when combined with the slow inventory growth, slashed 2.6 percentage points from the GDP.

The exact economic impact of the Fed’s ongoing policy is not precisely known, but Fed Chairman Ben Bernanke has argued in the past that prior rounds of “quantitative easing” have been a boon for economic growth.

In August, he cited a study that posited the prior two rounds of easing may have raised economic growth for the year by nearly 3 percent, which would suggest the economy would be contracting further without its unprecedented actions.

The Fed’s balance sheet has only continued to expand as bond purchases mount, recently topping $3 trillion for the first time ever.

The Fed’s policy remained the same on Wednesday, but the language used to present it had some telling changes.

In recent months, the Fed has described the economy as expanding moderately, but on Wednesday, it described the economy as “paused.”

It said disruptions from Hurricane Sandy and other “transitory factors” had halted economic growth and “downside risks” remained, but the central bank added that strains in global markets had eased.

Businesses, perhaps in response to the uncertainty posed by the “fiscal cliff,” also drew down on their inventories in the fourth quarter as opposed to generating fresh products. Wednesday’s report found businesses slashed their inventories by over $40 billion, which took a bite of 1.27 percent out of GDP.

At the same time, there are signs that the underlying economy is shaping up.

Personal consumption expenditures were up 2.2 percent in the fourth quarter, compared to 1.6 in the third. (Going forward, an important indicator will be how the end of the payroll tax cut affects consumer spending.)

Underlining that boost in personal spending was strong growth in personal income, which was up 7.9 percent, and disposable income, which was up 8.1 percent.

Purchases of durable goods also climbed by 13.9 percent, compared to 8.9 percent in the third quarter of 2012, and the decline in business inventory is a temporary drag.

The housing sector continued to show signs of life: Real residential fixed investment climbed 15.3 percent, up from 13.5 percent in the third quarter.

The strong underlying numbers led some analysts to predict the fourth quarter numbers would eventually be revised up.