Washington, D.C. © Corbis

Another budget battle is just around the corner in Washington, and it comes at a tough time for the economy.

While stocks are doing just fine right now, and job gains have been robust, the overall economy has been a bit underwhelming. Growth has averaged an annual rate of just 1% in the past nine months, the weakest since the recession ended, as cutbacks in federal spending and higher taxes on the well-to-do have sucked some of the wind out of its sails.

There are other concerns, too. China's clampdown on excessive and illicit lending practices has slowed the Middle Kingdom's economic juggernaut to a tepid pace. Markets, consumers and businesses are still adapting to the Federal Reserve's plans to pull back on its $85 billion-a-month bond purchase stimulus and the rise in interest rates that has accompanied it (10-year Treasury yields are up from 1.7% in May to 2.6% now).

So here we go again in Washington, as President Barack Obama and Republicans in Congress prepare for new clashes, this time over the 2014 budget and the Treasury's debt limit. They need to pass either a budget or a resolution to keep the government running before Oct. 1 -- and they have only a handful of working days to get it done.

If they do pass something, the economy looks ready to reaccelerate back toward a 3% growth rate, something Wall Street analysts expect. If they don't, we could be on the cusp of another 2011-style fiscal fright.

Another budget battle?

To be sure, everyone is tired of the rancor and the repeated fights over taxes and spending. A new Wall Street Journal/NBC poll shows that partisan gridlock has taken a toll: Obama's approval rating has fallen to its lowest level since late 2011 at just 45%, while Congress' approval rating is a laughable 12%. Just 29% of Americans believe the country is on the right track. And 57% say every member of Congress should be replaced.

Image: Anthony Mirhaydari - MSN Money

Anthony Mirhaydari

People understand deep down that major reforms are needed. The tax code is bloated and inefficient, with billions lost in compliance costs. Entitlement programs are overpromised, underfunded and pouring money into a system that overcharges for mediocre medical care. Infrastructure is literally crumbling. We're falling behind our global peers on things like education, high-speed Internet and high-value manufacturing.

The good news is progress is being made on the government's annual budget deficit, which is expected to shrink to less than 4% of gross domestic product this year and fall below 3% by 2015, a course that stabilizes the debt-to-GDP ratio in the 70%-73% range by 2023. Just two years ago, the forecasts said this critical ratio would reach 109% that same year -- with some economists warning that any number higher than 100% or so would damage the economy's long-term prospects.

Businesses are reacting to this, as noted by Société Générale economists in the chart below, with a drop in economic policy uncertainty and a slight rise on confidence. They see things getting better.

Policy uncertainty is on a decline

The cost of deficit reduction has been the drag on the economy from automatic budget cuts known as the sequester and from tax hikes earlier in the year. Together, they have sliced the GDP growth rate by about 2%, which suggests the underlying economy could manage something closer to 3% if it were unhindered.

But more needs to be done, especially on long-term entitlement programs, including Medicare and Social Security. Overall, the Committee for a Responsible Federal Budget says an additional $2.2 trillion needs to be taken out of the budget deficit over the next 10 years (in addition to the $1.2 trillion or so in cuts from the sequester) to put the national debt on a clear downward trajectory.

I'm cautiously optimistic that a deal will get done. Most likely, programs like Medicare will become means-tested. That will give Democrats a way to say they are socking it to the rich. And it will give Republicans a chance to say they have cut spending and prevented a tax hike. There is also some common ground on tax cuts for small businesses and manufacturers, the subject of Obama's speech earlier this week. Finding an agreement on reforming the tax code is also possible, but less likely than these two items.

The question is how they get there and whether the battles over the budget and the debt ceiling expand to include Obamacare as well. If so, it will make compromise much more difficult. And time is relatively short; after this week, Congress is in recess through Labor Day, then it has just nine official legislative workdays through the end of September.

Signs of strength

If we can get through the minefield in Washington, there is plenty to be optimistic about in the real economy. With many inventories depleted, new orders are flowing in to manufacturers as factories spool up again. The job market is tightening, forcing wages higher. Income tax withholdings, a real-time gauge of household earnings power, were up 6% in June -- the best performance for the month since 2007.

The economy also appears to be digesting the recent rise in interest rates rather well. Some of this is because the banking system has been and remains awash in extra cash, with excess reserves totaling nearly $1.9 trillion. That's a lot of extra money just sitting in bank vaults waiting to be lent out. As a result, UBS economist Maury Harris notes that bank lending standards are easing to an extent that's been associated, historically, with faster job growth and hasn't been seen since the 2004-2006 period.

That's keeping the momentum behind housing, where, despite the increase in mortgage rates, activity remains robust, thanks to higher expected prices and dwindling inventories. Auto sales continue to strengthen as well.