Hanging over Washington, DC for the past two months is the idea that full implementation of the fiscal cliff will likely push the economy into recession early next year. That's a conclusion driven by the Congressional Budget Office's August 22 report "An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022." You more often see references made to CBO's November 8 report "Economic Effects of Policies Contributing to Fiscal Tightening in 2013" because it's more directly on-point to the negotiations, but the November report doesn't do any updating of the underlying August model. So it's worth noting that the August report is outdated in a few important ways that may make the recession call obsolete.
Most notably, here's what CBO said about monetary policy:
CBO expects monetary policymakers to work to keep short- and long-term interest rates low, not only for the rest of the year but also over the next few years. Shortterm interest rates remained near zero in the first half of 2012, and they are likely to stay there for the rest of the year. Longer-term rates declined to extremely low levels in the first half of this year and have remained quite low, reflecting several factors: investors’ expectation that the U.S. economy will remain below its potential for quite a few years, investors’ concern over the banking and fiscal problems in Europe, and the Federal Reserve’s plan to continue purchasing long-term Treasury securities (under the maturity extension program, also known as Operation Twist).
In other words, in August the CBO basically forecast a continuation of then-current monetary policies. But in its September and December statements, the Fed shifted its policies in a way that may be relevant. What CBO said in August was that the combination of status quo monetary policy and the fiscal cliff would produce a situation in 2013 where real GDP falls 0.5 percent and the core PCE price index drops to 1.5 percent—well below the Fed's target. More recent policy statements from the Federal Reserve ought to give us some doubt that this would really take place. Ben Bernanke has said that the Fed neither can nor will fully offset the negative impact of the fiscal cliff, but the CBO call is based on the idea that the Fed won't do anything at all which strikes me as unlikely.
Now that's not to minimize the potential damage here. Even under a utopian scenario about monetary policy, the cliff has meaningful supply side consequences. I also don't think that resources idled by public sector spending cuts can be frictionlessly repurposed into private output simply by determined central banking. But the bottom line is that even under the very unlikely scenario where the full cliff is implemented, I think it's very unlikely that things would get as bad as CBO said in August or people fear today.