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Thomas Kenny

The "Sequester" Explained

By January 29, 2013

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The fiscal cliff may be out of the headlines, but a key aspect of it remains to be addressed: the sequester; or in other words, the spending cuts that were originally scheduled to go into effect in January. In the agreement made on New Year's Day, lawmakers addressed the tax portion of the cliff, but they postponed an agreement on cutting spending until March 1. With this deadline now approaching, you may be hearing more about the budget "sequester" in the weeks ahead. But how does it work exactly?

Very simply, the sequester is the $1.2 trillion in spending cuts that Congress agreed to in the Budget Control Act of August, 2011. Republicans required the scheduled cuts in exchange for raising the debt ceiling. These cuts involve $600 billion each in both defense and discretionary spending, and are scheduled to last from this year through 2021. This year, the impact would be about $1.2 billion if the entire sequestration kicks in. Now, Congress can let the sequester go into effect as scheduled or come up with a new budget deal to address the deficit via more targeted spending cuts.

As far as where we stand right now, The Economist provides the following summary in its January 23 article, "America's Economy Looking Better": "Republicans shifted the deadline on the debt ceiling principally to obtain leverage over Mr. Obama through the sequester--automatic, across-the-board spending cuts. If it kicks in as scheduled in March, Macroeconomic Advisers, a consultancy, reckons it would knock 0.7 percentage points off growth this year. Though both parties would like to replace the sequester with more gradual, selective deficit cuts, they cannot agree on how to do so. Then, at the end of March, a resolution that finances roughly a third of the government expires, raising the possibility of a government shutdown."

Elsewhere, the following quote from The Financial Times was highlighted by the Washington Post: "The $1.2 (trillion) in automatic spending cuts that Barack Obama once promised to avert are looking increasingly likely to occur because of entrenched politics in Washington, threatening a shock to confidence in the US economy. Economists have long assumed that the so-called sequester... would be replaced or reversed by Congress."

For investors, the bottom line is this: while the fiscal cliff agreement contributed to strong January performance for higher-risk assets such as stocks and high yield bonds - and corresponding weakness in safer investments such as U.S. Treasuries - don't assume February will bring more of the same. Before long, the fiscal debate in Washington will be back in the headlines.

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