FORTUNE — Markets today initially cheered the rough sketches of a highly anticipated deal to raise the U.S. government’s debt limit, but how the nation’s fragile economic recovery responds will depend on the final details of the plan and how it eventually rolls out.
After weeks of political wrangling, President Obama and congressional leaders reached a deal late Sunday night – thereby avoiding a default. The House is expected to vote on a plan later today, but needless to say, the drama isn’t over yet.
The deficit-reduction plan sets the stage for months of debates over how Washington taxes and spends. And it’s uncertain how a plan centered on spending cuts without tax increases will impact GDP growth, which has faltered since the summer of 2010. The question now is how much weaker could things get and could the scale of spending cuts prolong the incredibly soft patch?
An outline of the deal would raise the debt ceiling by $2.4 trillion in two stages. First, it would cut spending by $917 billion over the next 10 years. Then, a special committee would be tasked to find another $1.5 trillion in savings, which could come through tax overhauls and changes to social programs.
It appears lawmakers have tried to avoid any unforeseen hiccups to the plan. And who can blame them, given the political disaster that’s played out over the past few weeks? If the committee doesn’t find at least $1.2 trillion in savings, or Congress doesn’t adopt its proposals, a pre-set array of spending cuts would kick in. This could include cuts in military spending and Medicare payments to health-care providers.
However well intentioned, the plan doesn’t address the extent of today’s weak economic recovery. To be sure, the bulk of spending cuts wouldn’t kick in until 2013 and wouldn’t affect programs for low-income households, Social Security or Medicaid. Surely this gives the economy some time to heal before reeling in government spending, which currently makes up about 20% of GDP and the largest share of the U.S. economy next to consumption.
But judging by the latest reports on GDP growth, it has become increasingly uncertain when the economy will really starting picking up. During the second quarter, it grew by only 1.3% and revisions to previous quarters show a deeper recession and a weaker recovery than previously portrayed, according to forecasting firm Global IHS Insight. For the past six months, GDP grew at an annual rate of only 0.8%.
Prospects for a pickup during the second half of the year are fading fast. Even if the economy is no longer depressed by 2013, it will likely just have started growing in any meaningful way.
So while Congress might be breathing a slight sigh of relief once the debt ceiling is raised, this will likely put pressure on the Fed to act in an effort to – once again – jumpstart the economy. Perhaps Congress needs to pair this debt deal with a back-up QE3 plan?