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Friday, October 27, 2006

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:


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


[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.

    Posted by on Friday, October 27, 2006 at 02:58 PM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (2)  Comments (24)


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