Global stock markets have rallied after a short-term deal to stave off the US “fiscal cliff” was reached.
The Dow Jones gained 1.7% in morning Wall Street trading, while European shares were up about 2% for the day.
Failure to agree a deal would have triggered spending cuts and tax rises worth $600bn (£370bn), expected to throw the US back into recession.
However, the deal has only postponed by two months negotiations over spending cuts and the government debt ceiling.
Just before the New Year, the US Treasury Secretary Tim Geithner indicated that the federal government would run up against the debt ceiling – a legal cap on its total borrowing set by Congress – by the end of February.
The fiscal cliff deal does not include an increase in the debt ceiling. It also postpones by two months steep automatic spending cuts to federal government spending on things like defence and education.
The fiscal cliff measures – $536bn of tax rises and $109bn of spending cuts – had been due to come into effect at midnight on Monday.
The deal has averted most of these, including:
- making tax cuts that date back to George W Bush’s presidency permanent for individuals earning less than $400,000
- postponing $65bn of automatic spending cuts for two months
- keeping benefits for the long-term unemployed, worth $26bn, available for another year
- postponing for a year an $11bn cut in Medicare payments
However, the deal also allowed some tax rises to go ahead:
- the expiry of a payroll tax holiday, expected to raise $95bn in additional annual revenue
- allowing the Bush-era income tax cuts for individuals earning over $400,000 to come to an end, with the top rate increasing from 35% to 40%
- higher taxes on dividend income, capital gains and inheritance for these same top earners
- phasing out certain income tax deductions for individuals earning more than $200,000
“The majority of the tax increases are for the wealthy and shouldn’t impact consumption within the economy,” said Cromac Weldon, a fund manager at Threadneedle. “The last dollar someone on $450,000 earns is generally saved and not spent.
“However the 2% increase in payroll taxes will impact everyone, therefore we expect to see slightly less spending, or at least a constraint in spending growth, this year.”
Payroll tax is paid by all employees. The tax cut, which has now expired, was originally introduced by President Barack Obama three years ago to help stimulate the lethargic economy by putting more money in the pockets of ordinary American workers.
The US recovery has been gaining momentum since the summer, with jobs growth accelerating and the housing market turning the corner. Economists had feared that it would be knocked off course if the fiscal cliff went ahead in full.
The latest economic data released on Wednesday showed that activity in the US manufacturing sector began expanding again in December, according the latest monthly survey by the Institute for Supply Management.
However, the rate of expansion was weak, with many businesses postponing investment decisions due to uncertainty over the fiscal cliff.
Meanwhile the Commerce Department said that spending on construction fell 0.3% in November, due to reduced spending on public sector construction projects.
The fiscal cliff deal has postponed the hardest decisions that Republican and Democratic politicians must still reach agreement on – over spending cuts and the debt ceiling.
Both issues will need to be addressed at the end of February, with Republicans likely to demand deep cuts, particularly to entitlement programmes such as social security, in return for an increase in the legal cap on government borrowing.
Entitlement payments are expected to rise sharply in the coming decades as the post-World War II baby-boom generation retires and enters old age, entailing more government-funded medical care.
President Obama’s Democrats would prefer to reduce the government’s deficit via further tax rises.
“Out of the frying pan, into the fire,” said Paul Ashworth, US economist at Capital Economics.
“Given the cantankerous nature of the negotiations over the past ten days it is now very possible that we will see another stand-off over those spending cuts and the debt ceiling that leads to a shutdown of the federal government by late February or early March.”
When President Obama last faced off against the largely Republican-controlled Congress over the debt ceiling in 2011, negotiations went to the wire, unnerving financial markets and prompting ratings agency Standard and Poor’s to deprive the US of its top AAA credit rating.
Despite the deal’s shortcomings, markets took cheer from the fact that agreement had been reached on how to postpone and moderate the process of bringing the government’s overspending back under control.
The FTSE 100 index rose 127 points to 6,025 points, the first time it has been above the 6,000 level in 17 months, with mining shares leading the way.
The UK market was also boosted by a survey of production and new orders in the manufacturing sector, which showed activity at a 15-month high in December.
Shares worldwide had been hurt in November and December by fears that the US would not be able to reach any kind of agreement and would go off the cliff.
Analysts said the relief would not last.
Mike McCudden, head of derivatives at stockbroker Interactive Investor said: “There will no doubt be a few more twists and turns in the days ahead… but for now, investors have the concrete news they were hoping for.”