Fiscal Policy and Monetary Policy - Update

Market participants expected the November Employment Report to be the deciding factor on whether the Federal Reserve would begin to slow its rate of asset purchases this month. However, officials aren’t going to react to any one piece of data. The best argument for tapering is that it has to start sometime. However, the key factors that delayed the tapering in September and October are still with us to some extent.

Real GDP growth was revised to show a 3.6% annual rate in 3Q13 (vs. +2.8% in the advance estimate). However, most of that revision was due to faster inventory growth. Recall that GDP is a flow (amount per time) and inventories are a stock (amount). The change in inventories contributes to the level of GDP. Hence, the change in the change in inventories contributes to GDP growth. If inventories rise at a faster pace, that adds to GDP growth. If inventories rose more slowly, that subtracts from GDP growth. The third quarter’s pace was monstrous (see graph – similar to 3Q10). The rise in inventory growth accounted for nearly half of 3Q13 GDP growth. The inventory acceleration was likely unintentional, the result of lackluster demand (rather than stockpiling in anticipation of a surge in demand). The pace is almost certain to slow in 4Q13, perhaps sharply, subtracting significantly from GDP growth.

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Domestic Final Sales (GDP less net exports and the change in inventories), a measure of underlying domestic demand, rose at a 1.8% annual rate in 3Q13, up 1.4% y/y. Yet, despite a drag from the partial government shutdown, we may see stronger underlying growth in the fourth quarter.

The November Employment Report suggested that labor market conditions have continued to improve. Private-sector payrolls averaged a 193,000 monthly gain over the last three months (also a 193,000 average over the last 12 months). Job gains were broad-based across industries.

The unemployment rate sank to 7.0%, a level which Fed Chairman Bernanke had suggested (back in July) would be consistent with an end of the Fed asset purchase program (QE3). Whoops. Unemployment rates for teenagers and young adults have been sharply elevated in recent years. Monthly changes can be erratic (due to difficulties in seasonal adjustment), but these rates appear to be trending lower.

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In contrast, the unemployment rate for the main cohort, those aged 25-55 years, was the same as in September (it was lifted slightly in October due to the government shutdown). The employment/population ratio for those aged 25-55 was 75.9%, trending roughly flat over the last year and a half (it was around 80% before the recession). In short, the job market is improving, but is a long way from normal.

In September, Fed Chairman Bernanke cited three reasons for the delay in tapering. 1) The Fed wanted to observe the impact of tighter credit conditions (higher long-term interest rates). Recent housing data suggest some softening. If the increase in long-term interest rates is due to an improved economic outlook, that’s not a problem. However, if the increase is due to expectations of tighter monetary policy, that’s bad (not what the Fed intended). 2) The Fed wanted to see how uncertainty in Washington played out. Lawmakers are reported to be near a mini-deal on the budget and debt ceiling. This isn’t the grand bargain they were tasked with (a long-term plan), but it should suffice. Another government shutdown is unlikely. 3) Inflation was trending low. The PCE Price Index, the Fed’s chief inflation gauge, rose 0.7% over the 12 months ending in November, with the core rate up 1.1% – still low and far below the 2% target.

Tapering is still a possibility for December. The Fed could reduce the rate of asset purchases modestly and suggest that it will wait a long time before tapering again. However, officials haven’t prepared the financial markets for such an outcome.

© Raymond James

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