Fed Watch: Soft GDP Report Anticipated by The Fed

Tim Duy with a Fed Watch following today's disappointing report on real GDP growth:

Soft GDP Report Anticipated by The Fed, by Tim Duy: Brad DeLong responds to the headline GDP number with some hand wringing:

Gork!

The BEA says:

GDP (Third Quarter 2006 (advance)): 1.6% [per year]

The odds of the Fed's cutting interest rates soon just went up.

More to follow...

I like the title – I can imagine Brad saying “gork” while settling down with his morning coffee. Unsurprisingly, Nouriel Roubini finds occasion to gloat:

The first estimate of Q3 GDP growth is a dismal 1.6%, sharply lower than the 5.6% of Q1 and the 2.6% of Q2. In July - when I first predicted a US recession in 2007 - I forecasted that Q3 GDP growth would be 1.5% at the time when the market consensus was 3.1%.

Of course, Nouriel can’t help himself but to take the opportunity to double down on his bet that the US is headed toward a recession:

The first leading indicator of economic activity for October – the Philly, Richmond and Chicago Fed reports – are all consistent with a further economic slowdown in Q4 relative to Q3. I thus keep my forecast that Q4 growth will be between 0% and 1% and that the economy will enter into an outright recession by Q1 of 2007 or, at the latest, Q2.

But more on Nouriel later. The spectrum of economists was well represented in the Wall Street Journal ($$$). Pick the economist that best fits with your trading strategy:

[T]he markets are already split between [inflation] rebound or further softness in the fourth quarter. We expect the latter, triggering a Fed ease [of interest rates] in March. -- Ian Shepherdson, High Frequency Economics

or

[T]he Fed got the moderation in growth that it was expecting and hoping for … However, any expectations of Fed easing at this point would be very premature, in our judgment, as demand growth was fairly solid outside of housing and, partly fueled by real income gains from lower energy prices … we continue to expect the next move from the Fed to be a rate hike, but we see such a move as being data dependent and not occurring until the January/March timeframe. -- John Ryding, Bear Stearns

The latter is a good place for me to take over. This GDP report was anticipated by the Fed, and by adding an explicit forecast into Wednesday’s FOMC statement: “Going forward, the economy seems likely to expand at a moderate pace.” This was a deliberate effort to get ahead of the data, and stave off expectations of a rate cut. Did it work? Given the rally in bonds and the comments of DeLong and Shepherdson, I would say “not really.” Nor am I surprised. The Fed is fighting against history here, as Kash reminds us.

The Fed will not lose much sleep over this GDP report. Yes, the headline number is low. But the devil is in the details, and the Fed will be drawn toward three in particular. The first is the 3.1% gain in consumption spending – the wealth effect from a declining housing market has yet to hit consumers in earnest. The second is the 8.6% gain in fixed investment, and the revival of equipment and software spending to a 6.4% rate. Outside housing, investment spending is slowing, not collapsing. The third point is the import surge. Underlying domestic demand must be pretty strong; we can’t remotely satisfy our consumptive desires on domestic productive capacities.

The Fed will also be drawn to the deceleration in core inflation; core-PCE rose at 2.3% annual rate, down from the 2.7% rate in the second quarter. Still, inflation remains too high, and Fed officials will remain vigilant.

In short, the GDP report is consistent with the Fed’s view on the economy: A slowdown in the housing sector, with minimal spillover into other parts of the economy, and moderating inflation numbers. For the Fed, these are “stay the course” numbers (for some reason, I just can’t get that phrase out of my head).

But the third quarter is now behind us, sunk cost, history. We are already one month into the fourth quarter, which is where the real action will happen. First, will the wealth effect bite in consumers? Nouriel (of course), thinks so:

This weakness in residential and non-residential construction will directly affect retail activity where employment has already started to fall. Expect in Q4 and 2007 actual fall in durable consumption (autos, housing related consumption such as furniture and home appliances and other big ticket items) as the housing slowdown, the fall in home prices and the negative wealth effects of falling prices and reset of ARMs take a toll on consumption, especially housing-related durable one.

I suppose somebody has to be the anti-Nouriel, if only to maintain a “fair and balanced” blogsphere. Note that Nouriel cleverly covers his back by limiting his analysis to the volatile durable goods component, limiting his exposure on his claim that consumer spending is about to collapse. Recall from Nouriel’s take on the 2Q06 GDP report:

Real private consumption (that is 70% of aggregate demand) was growing only 2.5% in Q2, with durable goods consumption actually falling 0.5% led by lower purchases of cars and of goods related to housing: as housing slumps consumers are buying less furniture, home appliances, etc.. Expect even worse consumption growth in H2, as a further slumping housing sector, higher oil prices and high interest rates are seriously shaking saving-less, debt-ridden consumers whose real wages are falling.

So far, consumption growth is accelerating, not deteriorating in H2. Why aren’t households listening to Nouriel? Don’t they get it? On a basic psychological level, it is always good to touch base with Keynes:

For a man’s habitual standard of life usually has the first claim on his income, and he is apt to save the difference which discovers itself between his actual income and the expense of his habitual habit; or, if he does adjust his expenditures to changes in his income, he will over short periods do so imperfectly.

This phrase is both underlined AND starred in my copy of The General Theory, so it must be important. It serves to remind me that consumer behavior changes slowly, especially on the downside. Once you are accustomed to a certain standard of living, you tend to resist downsizing. Hence why consumer spending rarely shifts as quickly as economists think it should.

Will 4Q be the turning point for consumers? Not so far, according to the early data. The University of Michigan reading on consumer sentiment jumped in October, telling me that consumers are happy. And only one thing makes consumers happy – SPENDING. Plus, they still have their jobs; initial unemployment claims continue to hover around 300k. Nothing to lose sleep about on that point. Moreover, real incomes are rising: according the GDP report, real disposable personal income stands 3.9% higher than 3Q05.

Oh, and oil prices fell.

Turning toward investment, I believe this is where you need to push to generate a recession. Specifically, business investment. Calculated Risk argues that declining residential investment will be followed by declining nonres fixed investment. This is the risk factor I am watching, but so far not seeing. Note that the pace of new orders for nondefence, nonaircraft capital goods accelerated through the second quarter, rising 0.6%, 0.8%, and 1.1% for July, August, and September (watch – October they will drop). Unfilled orders continue to grow as well.

Also, there is a reasonable chance that investment spending is held back by the delayed launch of Windows Vista. And note this from Bloomberg:

Norfolk Southern Corp., the fourth-largest U.S. railroad, boosted freight rates, helping third-quarter profit increase 38 percent. Sales rose 11 percent.

''Overall, we don't see any drastic slowing of the entire economy,'' Norfolk Southern Chief Executive Officer Charles ``Wick'' Moorman said in an interview. ``We think that pricing power will stay with us for a while.''

I pay attention to what the rail barons say – they generally have a good sense of economic activity.

Turning toward the jump in imports leads me to this bizarre claim:

The housing sector and the growing trade deficit were the main culprits … subtract[ing] from growth 1.1% and 1.3%, respectively. Confounding naysayers, consumers and business investment continued to stave off the recession that the housing adjustment and the tide of imports could easily cause. -- Peter Morici, University of Maryland

A “tide in imports” is almost certainly NOT going to cause a recession. Yes, yes, it contributes negatively to GDP, but only because we are buying more stuff than we can produce domestically. Rising imports must indicate strong demand. A positive contribution from imports – import compression – would be more consistent with weak economic conditions. For example, imports contributed positively to growth in 2001 and 2002. Has everyone forgotten that little party called the Asian financial crisis? Serious import compression. I suspect that crowded port conditions are pushing the Holiday import binge earlier into the year, and the seasonals have not quite caught up. If so, import growth will not be so strong in Q4.

All right, I have rattled off enough for one blog. I believe the risk of a hard landing is not insignificant, but recent data does not point in that direction. We are not seeing the hallmarks of a hard landing such as collapsing core durable goods orders, rising jobless claims, or plummeting consumer confidence. Without those signals, the Fed will stick to the soft landing story. Consequently, the Fed is not likely to view 3Q06 report as disastrous; they will view as in line with their expectations. Will those expectations be correct? Time will tell.

Comments

[maria]

Hey this is going to be fun to watch. Thoma v. Roubini. I bet on Roubini. Sorry, Mark.

[maria]

I might add that Political Calculations that predicts recessions based on the spread between 3 month and 10 year treasuries has zoomed up to 49.8% chance. Highest for several years.

[Dave Iverson]

Mark,

Nice post. Interesting to see you and Dave Altig ("macroblog," for those not following Altig's stuff) both playing off Roubini in recent posts. I have a question and since I'm lazy I'll just ask you: You report that "according the GDP report, real disposable personal income stands 3.9% higher than 3Q05." Does the GDP report "median" or "mean" personal income? I suspect that if "mean" then the statistic may not be helpful to your argument, or at least not nearly as helpful.

[Idaho_Spud]

I kinda lean toward Roubini too. In part because he nailed the number, but mostly because he is so articulate and convincing about the multiple threats our economy faces and the fine line the Fed is trying to walk between inflation and recession. This is the first hint that they are losing both battles.

Safe to say mass layoffs are (if not already announced) in the pipeline for residential construction, mortgage lending, and real estate - the very trades that have generated the most jobs post-recession.

As CR might say, I'm 'not sanguine' about Q4 or Q1 2007 either. There doesn't seem to be anything big enough to buffer the coming loss of housing-derived income & MEW.

[Dave Iverson]

Whoops. I guess it is Tim who is playing off Roubini.

[bsetser]

I think it is Duy v. Roubini, and I'll stay neutral, since I am friends with both.

Tim, your musings on imports are interesting. My sense tho is that the seasonals may work in the other way -- I consistently suspect that q1 seasonals don't fully accout for the Chinese new year, and that the seasonality functions haven't been updated for the growth in the pacific trade (i.e. US holidays in q4 = consumption binge, chinese new year in q1 = production fall off). Certainly one of the unusual features of both 05 and 06 is that seasonally adjusted non-oil imports were flat in h1 and then jumped in h2. part of me wonders if the seasonality adjustment hasn't quite caught up with trade patterns, so the imports in q1 aren't being adjusted up enough and thus what appears like an import slowdown is really just asian seasonality. In any case, last year there was a big blow out in non-oil imports in q4. This year looks to have a big increase in q3. The Asian data in october should give some sense of what q4 might look like -- september Asian exports suggest quite large US imports. tho of course lower oil prices may mask some of this in the headline numbers.

just some musings.

and, based on your keynes reference, tis worth noting that with investment falling and the current account deficit growing (it should be @7% of GDP in q3), well, savings necessarily was falling faster than investment -- allowing us to maintain our accustomed levels of spending.

[Dave Iverson]

Here's an Economic Policy Institute article [PDF] that lends credence to my earlier question/supposition as to "mean" v. "median" personal income growth. An embedded graphic shows personal "median" income dropping since about mid-2004 (or since 2002 depending on how you view the graph). Maybe that's turned around. Maybe not.

[Tim Duy]

Brad:

Perhaps I shouldn't even go down the road of musing about changing seasonal patterns. It is a version of the "data is wrong" argument, which is not one of my favorites. Was no need to go down that road anyway.

And you are correct - reported saving is likely falling to hold the statistical ball of wax together. When will it end....will there be a day of reckoning, or is this some new paradigm? As you know, I expect some import compression ahead.....it is all about timing.

Dave:

Real DPI is total, not mean or median.

Tim

[Dave Iverson]

Thanks Tim,

You better than I to go down that "road of musing about changing seasonal patterns." But it's a tricky one to navigate. Still, I appreciate your perspectives, as I do those of Nouriel and Brad, Mark and others. You folks have helped me bootstrap myself into at least a basic understanding of geopolitics and international finance. And like you I sense a "compression ahead." I just hope it doesn't turn into something deeper and protracted based on policies that proved, in retrospect, to be too expansive for too long setting a stage for speculative frenzy the will yet prove hard to contain. And with too many losers on the other side, with too much leverage thereby reversing the ratchet effect from irrational exuberance to irrational pessimism.

[Emmanuel]

Dr. Setser: Of course, you are also employed by Dr. Roubini :-)

TD: To be fair to Nouriel Roubini, you did omit mentioning that the ARMs resets he cites will start more towards early next year. Timing helps explain why Q3 consumer spending by the buying automatons wasn't much affected. Here's some anecdotal evidence that that's starting to happen. Can't say I feel too sorry for them:

In this year's first six months, only 49% of American mortgage originations were fixed rate and the majority carried adjustable interest rates, Duncan reported at the convention.

With $1 trillion in adjustable-interest rate mortgages due to reset next year, "it's going to take some people's mortgage payments from the hundreds of dollars to the thousands," said Daniel H. Mudd, president and CEO of Fannie Mae in Washington D.C., the nation's largest mortgage buyer.

[maria]

By Carlos Torres

Oct. 27 (Bloomberg) -- An unexpected increase in auto production last quarter was a statistical fluke that will be reversed, making current U.S. economic growth even weaker, according to a former Commerce Department economist.

Last quarter's annualized 26 percent increase in auto production shocked Joe Carson, now director of economic research at AllianceBernstein LP in New York. Without the gain, the economy would have grown at an annual rate of 0.9 percent, not the 1.6 percent the Commerce Department reported today.

Roubini far too bullish. LOL

[evagrius]

"For a man’s habitual standard of life usually has the first claim on his income, and he is apt to save the difference which discovers itself between his actual income and the expense of his habitual habit; or, if he does adjust his expenditures to changes in his income, he will over short periods do so imperfectly."

Gee, this sounds like the behavior of a junkie.

I know, crass, and not exactly insighful.

[Winslow R.]

I still tend to think this election, if 'free and fair', will have a bigger impact on the economy than most anything else. If the Dem's take over I see gridlock taking over, making any new fiscal stimulus (new war or otherwise) highly unlikely. General trend is still deflation and unless Diebold comes through for the Repub's, likely to stay that way. As of now, I am leaning towards Roubini.

says...

The war in Iraq has been the most impressive U.S. endeavor ever. They have prevented Hussein from acquiring WMDs and brought stability to the entire region. It is simply unbelieveable that this administration does not get more credit- we haven't had an attack on our home soil in 5 years- despite numerous attempts. The price of oil is stabilizing, had we not gone into Iraq the price would surely exceed 100/barrell- I don't even need to post the empirical evidence to support that. Has anyone seen the show Heroes? George W Bush, Dick Cheney and Rummy are the super human powers that have saved NYC and the rest of this country from nuclear destruction. God Bless the heroes, God bless the United States and God bless all you raisin brained sheep.

[maria]

Hey Mr. Noname, you crack me up. You are really funny and I hope you keep it coming. We will need plenty of comic relief going into the approaching recession.

says...

Soros also was predicting a 2007 recession as early as January 2006.

http://www.ameinfo.com/75420.html

[EZRider]

We've been through recessions before, we'll make it through this one.

If my calculations are correct, the US's GDP is 3.26 though the third quarter. That seems about average for a country this size/industrial capacity. Am I wrong?

[calmo]

EZR asks "Am I wrong?"
Lovely.
And engaging too. [This B that.]
Who could be wrong with their GDP estimate? (It's not as if there are good guesses and lousy ones.) There are powerful calculations that are vindicated by the official number. [Some calculations too powerful to print -like yours (so far).]
This could mean using the same darts, the same astrologer, the same Taro cards...

Of course we'll make it through the recession, I'm a Taurus, you?

[anon/portly]

That was one amazing Fed Watch. But now I'm worried about stylistic flair crowding out analytical flair - what data did Tim Duy omit to inspect while sharpening his prose?

Along the same lines, show me an economist today - even in the relative safety of a blog - who'd write "the difference which discovers itself between" instead of just "the difference between," or "habitual habit." Them were different times.

[calmo]

Ok, anon/portlyBut now I'm worried about stylistic flair crowding out analytical flairI'd say the stylistic flair here has already made that move on analysis, you?
U B right, stile B all.
The minutes (not mere "records" forpetesake!) are excruciatingly particlar about them words. [slink would neva make it people]
The safety of a blog? U gotta B kidding. It can be murderous here. (If you don't respond it could be curtains for your reputation.) [If you are not timely with your response, people think you are slow and not, say, at war with your keyboard.]
Tim needs no safety and finds no safety here IMTERRORIZINGO. He writes well and, with few exceptions (maybe you identify 1 but not 2) his prose does not compromise his analysis.

[EZRIder]

"[Some calculations too powerful to print -like yours (so far).]
This could mean using the same darts, the same astrologer, the same Taro cards..."

Of course we'll make it through the recession, I'm a Taurus, you?"

I am not economist. The GDP number I came up with is the average of the first three quarters of this year.

Some people treat recessions as if the worlds going to end. They can be bad. I've made it through a few myself. I have come to expect them.

[anon/portly]

"He writes well and, with few exceptions (maybe you identify 1 but not 2) his prose does not compromise his analysis."

I agree; my only real (if as usual unintelligible) point was I thought his post was quite amusing.

But then again, I wonder really about the idea of (intentionally) funny economists. Is the DS a S without the D? Perhaps if we start allowing economists to have a sense of humor we will look back on it one day as one of those ideas, like giving dogs the vote or electric food, that seemed better in theory than in practice.

[Rick]

Mark for those of us that are members of the Aries "alpha male" camp, we understand the difference between "corporate" productivity and productivity measured by governmental beancounters per standard metrics. How many quarters of double-digit top and bottom-line gains is it now thanks to those hunky captains of industry? Such correlation to the lack of real-wage increases (as the dollar continues to loose relative value) in the U.S. surely has something to do with the recent popularity of investing in large-cap dividend payers; where else are we to find a rise in our pay-packets?

[rezaul]

would you please send to me the malaysian real gdp of last 10 year.