The markets have placed too much emphasis on the Fed tapering. Whether policymakers decide to slow the rate of asset purchases in September or December shouldn’t matter all that much. The Fed’s decision will be data-dependent. Note that it’s not the figures themselves that matter. Rather, it’s what the data imply for the overall economic outlook.
Most investors are aware that the measurement of Gross Domestic Product, the sum of final goods and services produced (or consumed) each quarter, is difficult. Figures get revised, and revised, and revised. The government does not have a complete picture of the economy in the advance estimate. More component data will become available over time and the components themselves are subject to revision. It’s not unusual to see the growth estimate eventually reported a full percentage point higher or lower than the initial estimate. While the financial markets emphasize the headline GDP figure, it’s usually much better to focus on the underlying story. What are the strengths and weaknesses in the component data, and what do they suggest for the future?
Consumer spending accounts for roughly 70% of overall GDP. Figures for April and May showed a lackluster, but positive, trend in 2Q13 – most likely in the 1.5-2.0% range (annual rate). There are mixed forces at work on the consumer sector. Lagged effects of the payroll tax increase likely dampened consumer spending growth in the second quarter. However, wealth gains in housing and the stock market provided some support. Conditions vary considerably across the income scale. Inflation-adjusted wage income has been stagnant for the typical worker, but job growth contributes to growth in aggregate wages. Note that eating and drinking establishments accounted for a quarter of the gains in nonfarm payrolls in 2Q13. That’s consistent with increased consumer confidence.
Business fixed investment is likely to have been weak in the second quarter. Shipments of nondefense capital goods ex-aircraft fell relative to the first quarter. So we may see expenditures on business equipment subtracting from overall growth. This release will incorporate comprehensive revisions to the GDP data. Business expenditures on intellectual property products will be capitalized (rather than expensed), adding to business fixed investment. Business spending on computer software was added to the GDP accounts in 1999, and will become part of the new Intellectual Property Products category with this GDP release. Research and development expenditures should raise the level of GDP by about 2.2%. Expenditures on entertainment, literary, and artistic originals – reflecting long-lasting ownership rights used in the production process – will raise the level of GDP another 0.7%.
Residential construction should add to fixed investment, but homebuilding is a relatively small part of the overall economy. Net exports are likely to subtract from GDP growth, due to higher imports (which have a negative sign in the GDP calculation) and softer exports (reflecting a soft global economy). Inventory growth is likely to have slowed in the quarter. Remember, the change in inventories contributes to the level of GDP. The change in the change in inventories contributes to GDP growth. Thus, a slower rate of inventory accumulation subtracts from GDP growth. However, leaner inventories typically suggest the potential for strong production gains ahead, as inventories are rebuilt.
The median forecast for 2Q13 GDP growth is about 1.0%, but we could see a surprise to the downside, depending on what the government assumes about foreign trade and inventories in June. Sequester spending cuts have been spread out over time, but government is likely to remain a drag on overall growth.
While the GDP data tell us where the economy has been, they don’t tell us much about where things are headed. Clearly, the housing sector has turned the corner and is providing important support for the overall economy. However, fiscal policy has been a significant drag on growth. It’s likely that the fiscal drag will wane in the remainder of the year. However, nobody, including those at the Fed, is precisely certain about that.
The Employment Report should provide a better indication of where the economy is headed. Payroll growth is expected to have remained relatively strong in July, but seasonal adjustment can often be tricky. There will be another employment report before the September 17-18 Fed policy meeting.
Bernanke and other officials have been clear about the Fed’s intentions regarding the asset purchase program. The reaction in the financial markets was puzzling and unwelcome. Long-term interest rates should be driven by expectations of short-term rates, and short-term rates aren’t going anywhere for some time (the first increase is seen in 2015). It shouldn’t matter much whether the Fed begins to slow the rate of asset purchases in September or December. The minutes of the June 18-19 FOMC meeting showed that some officials were worried that talk of tapering might send the wrong signal to the markets. Long-term interest rates have risen enough that they may dampen the pace of growth in the near term. Will the Fed respond by suggesting that tapering will be delayed? Probably not. Rather, we should see a continued emphasis this week on the Fed’s forward guidance (on short-term interest rates).
President Obama should soon nominate Bernanke’s replacement. Some in the administration are pushing for Larry Summers, but the markets are hoping that it’ll be Janet Yellen.
© Raymond James