The busy week of economic news left investors uneasy. The 4.0% GDP growth figure contributed to concerns that the Fed may be forced to raise short-term interest rates sooner rather than later. However, while the economic data reports, and even the Fed policy statement, had something for everybody, the outlook for monetary policy should be essentially unchanged.
Real GDP rose more than expected in the advance estimate for 2Q14 and benchmark revisions showed a somewhat smaller decline in 1Q14 than was reported earlier (-2.1%, vs. -2.9%). That left the average pace for the first half of 2014 at 0.9%, vs. expectations of around 0.0%. Well, whoop-dee-doo! The surprise in the GDP report was the rapid pace of inventory accumulation, which accounted for a little over 40% of the quarter’s growth (1.66 percentage points). Inventory growth is often tough to interpret. It could be unintentional, the result of unexpectedly weak demand, or it could be planned, based on expectations of increased demand. It’s usually hard to say. Moreover, these figures have a tendency to get revised (the 2Q14 GDP figures will be revised on August 28 and again on September 26). Taken at face value, the second quarter’s pace of inventory growth will be difficult to maintain. Hence, if we don’t get revisions to the 2Q14 figures, we should see the pace drop in 3Q14 or in 4Q14, restraining overall GDP growth.
Domestic Final Sales (GDP less net exports and the change in inventories) provides a more stable picture of underlying domestic demand. DFS rose at a 2.8% annual rate in 2Q14, vs. +0.7% in 1Q14, for a first-half average of 1.8%.
The key question is, does this tell us anything about the second half of the year? Well, not much. Many of the recent economic data releases, such as retail sales and industrial production, have painted a similar picture. That is, growth rebounded in the second quarter, from weather-related weakness in 1Q14, but the monthly figures suggested some loss of momentum in June. One of the key concerns has not been that the economy would slump back into recession this year, but rather, that we’d end up with “more of the same,” with the economy continuing to recover, but at only a moderate pace, where the excesses generated in the economic downturn would continue to be mopped up only gradually over time.
The recent data reports suggest a mixed outlook. Job growth has been strong, but real average wage growth has been flat. Personal income and spending figures show moderate growth heading toward the second half of the year, but the housing recovery has been a major disappointment. A sluggish global economy will likely restrain growth in exports, while geopolitical worries could lead to more cautious business attitudes in general (firms being somewhat less likely to hire or make capital expenditures). In short, there are a variety of crosscurrents, but the pace of growth is likely to remain moderately strong.
Fears of inflation are overdone. The PCE Price Index picked up in 2Q14, but the year-over-year pace remained well below the Fed’s 2% target. Pipeline inflation pressures appear mild. Inflation expectations remain well-anchored. The Employment Cost Index accelerated to 0.7% over the three months ending in June, but that followed a subpar 0.3% pace over the three months ending in March. The ECI rose 2.0% over the last 12 months, about the same pace as the three previous years. As Fed Chair Yellen pointed out, we should see the ECI trending between 3% and 4% under normal job market conditions. The low trend in labor compensation can be taken as one sign of slack in the job market.
In its policy statement, the FOMC noted that the unemployment rate has declined further. However, it also stressed that “a range of labor market indicators suggests that there remains significant underutilization of labor resources.” This concern will remain a key factor in the Fed policy outlook. Financial market participants will want to pay close attention to the Kansas City Fed’s upcoming monetary policy symposium in Jackson Hole, Wyoming. Each of these annual meetings of central bankers from around the world has a theme. This year, it’s “Re-Evaluating Labor Market Dynamics.” We could see policymakers rethink their views on the job market, but more likely, the discussions may reinforce the Fed’s resolve to let the economy run (to reduce the amount of slack). We’ll see.
The FOMC statement and recent data reports give inflation hawks something to squawk about, but the majority opinion of Fed policymakers should be unchanged. The FOMC will continue to refine its exit strategies, but there’s no sign that it is behind the curve on inflation. Policy actions in 2015 will be dictated by the evolution of the economic outlook in 2H14.
