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Budget stalemate has already hurt the economy

Economists have been warning for months that failure to raise the federal debt ceiling before the Treasury runs out of cash could jeopardize an already fragile recovery. Now, it’s beginning to look like the damage may have already been done.

As Congress and the White House push their budget battle closer to the brink of busting the government, consumers and businesses are growing more anxious.

“The uncertainty associated with the news flow out of Washington … is really having an impact on consumer and business confidence,” RBS Senior Economist Michelle Girard told CNBC. “Right now for the U.S. economy it's all about confidence because businesses certainly have the wherewithal to hire and invest. But they're just hesitant to do so because no one is quite sure where this all ends up.”

That uncertainty is already starting to show up in the latest round of monthly economic data. Industrial output hit the brakes in June, rising a modest 0.2 percent, according to the Federal Reserve. Retail sales and hiring have slowed sharply. On Friday, a widely watched survey of consumer sentiment showed Americans have turned gloomier than they’ve been since March 2009, when the economy was still contracting.

“This is an indication that the not-handling of the debt ceiling in Washington is certainly impairing consumer confidence,” said Ward McCarthy, chief financial economist at Jefferies. “I would be very surprised if that were due to anything besides the fact that the government at this point in time is not making us all feel good about things."

The ongoing display of political dysfunction is also eroding the confidence of investors who, until recently, saw a deliberate default by the government as unimaginable. Though most of Wall Street still believes a last-minute deal will be reached to raise the debt ceiling, the budget battle has begun taking a toll on the stock market, which headed lower on Monday. The price of gold shot to record highs above $1,600 an ounce.   

To be sure, some of the current economic weakness has been caused by temporary factors like a surge in oil prices in the first half of the year and the supply disruptions brought by the massive earthquake in Japan. Federal Reserve Chairman Ben Bernanke recently said that the fading impact of those events should provide some relief.

The widening debt crisis in Europe is also weighing on investors U.S. businesses, especially those that generate substantial profits selling to European markets.

With more signals flashing red, economists have cut their forecasts for the second half of the year, according to a survey of business economists released Monday. Some 76 percent said they still expect gross domestic product to grow by at a 2 percent pace in the second half of the year, down from 94 percent in the April survey. The share that expects GDP growth at 2 percent or below swelled to 23 percent, from 5 percent three months ago. Just 11 percent are still looking for the economy's growth rate to top 3 percent, down from 37 percent in April.

On Friday, Goldman Sachs lowered its second quarter growth rate forecast by a half percent to 1.5 percent; it now forecasts third quarter growth of 2.5 percent, down from 3.25 percent.

If Congress and the White House can reach an agreement, the mood among business leaders and consumers could improve. But Goldman Sachs chief economist Jan Hatzius told clients in a research note Friday that the mood is so bad, the firm’s latest forecast may still be too optimistic.

“We would probably need to see a substantial improvement to undo the dramatic (damage to sentiment) and to avert further downgrades to our GDP growth estimates for the fourth quarter and 2012. Unfortunately, our confidence in the growth forecast remains relatively low.”

Confidence has also waned in the latest forecasts from the Fed, which recently ended its program of buying hundreds of billions of dollars in government bonds to push cash into the financial system, keep interest rates at record lows and give the economy a boost. Last week, Bernanke told Congress that, while the central bank is ready to revive its easy-money policies, it’s essentially on standby while it waits for the recovery to pick up speed in the second half of the year.

Bernanke testified that Fed policymakers predict the economy will end 2011 with an annual growth rate of between 2.7 to 2.9 percent. With growth in the first half expected to barely break 2 percent, that would imply a healthy growth revival to well over a 3 percent pace in the second quarter. The Fed forecast also sees the jobless rate falling to between 8.6 and 8.9 percent by the end of the year, from 9.2 percent in the latest reading.

That’s not likely, according to Wells Fargo chief economist John Silvia. He sees GDP growing at no more than 2 percent for the year and the unemployment rate falling no lower than 8.9 percent.

Even if the budget talks result in an eleventh-hour deal, it may take more than a high-profile press conference to restore confidence that the crisis has passed. Wall Street bond rating agencies Moody’s and Standard and Poor's have warned that failure to come up with substantial solution to rein in the current $1.4 trillion budget deficit could cost the government the AAA rating that allows it to borrow cheaply from investors.

Higher borrowing costs on U.S. Treasuries would quickly raise the cost of taking out a mortgage or car loan, further crimping consumer spending. As borrowing costs rise, businesses are less likely to expand and take on new workers.

It’s not the first time a political stalemate has hurt the job market, according to Dean Maki chief US economist at Barclay’s’ Capital. The budget standoff in late 1995 that temporarily shut down the government also sent companies slamming on the hiring brakes.

“As was the case then, the current negotiations are similarly raising uncertainty and posing a risk to the labor market,” said Maki.