MARKETWATCH:Week September 27 – October 1, 2010

The growth play from September has spilled over into October, although cross-currents are apparent and volatility should be expected. Economic news, while not great, has been better than expected (including news coming from China), so risk worries have receded for the time being. Cutting both ways in financial markets, signs (including today’s comments by NY Fed President Bill Dudley) may have raised expectations further that the Fed is on the verge of increasing support to the economy because of concerns over the economy’s weakness.

Hovering in the background are possible spillover effects from the Irish financial and fiscal situation (so far managed and contained, reminiscent of the Swedish crisis of earlier years – but we shall see).

Also, emerging from the wings is the rising perception of political risk due to fiscal policy uncertainty, with a possible impact on the economy and financial markets. Real effects may be starting to surface. Employer hiring and consumer spending may already have started to be dampened by uncertainty over their 2011 tax bill – taxes will go up starting in around 90 days unless Congress says otherwise after the election. There may also be some income/earnings shifting from 2011 to the present to minimize tax exposure. Moreover, with economic weakness already a concern, the withdrawal of additional demand if the 2001 tax cuts are allowed to expire could well be food for thought as the Fed considers whether to supply more liquidity to support the economy – and when.

Looking at our current situation from a longer perspective, Congressional Budget Office Director Elmendorf’s recent testimony and CBO’s accompanying work illustrate the delicate fiscal balancing act we all face to make sure the economy has sufficient support now but to limit the cost to the economy later this decade when presumably it returns to full employment. Our challenges: deflation is very costly, as the lost decade in Japan shows so vividly; high and persistent unemployment can become a structural issue, with large costs for the economy as well. Yet, taking on higher debt to address our immediate problems will have long-run costs. Debt always must be paid for, one way or another. One way to balance and manage our short and long-run challenges is through a credibly back-loaded fiscal recovery plan, agreed and announced sooner rather than later and applied gradually over multiple years.