Last Friday we learned that the economy grew a paltry 1.2% in the second quarter – less than half of the consensus expectation of 2.5% and only marginally better than the 0.8% growth in the first quarter. In response to the disappointing report, many economists are now saying they no longer expect the Federal Reserve to hike interest rates until 2017 (at the earliest). They say that even though the unemployment rate has dropped to less than half of its financial-crisis high of 10%, a variety of risk factors remain that could threaten the Fed’s dual mandates of maximizing employment and maintaining price stability. Are these economists right about the Fed? And if so, is the Fed right in continuing to defer rate hikes?
Let’s begin with the formula for Gross Domestic Product, or GDP.
Personal Consumption simply refers to consumer spending on both goods and services, and this category comprises about 68% of total GDP in the United States. Gross Private Domestic Investment, which currently comprises about 18% of GDP, consists of investments by private businesses, nonprofit institutions, and households on structures, equipment, and software that are used in the production of goods and services. This category also includes the change in business inventories in a given period as inventories also represent investments. Government Spending, comprising about 17% of GDP, includes all levels of government. And finally, Net Exports are currently reducing our GDP by about 3%. Exports add to the GDP, and Imports subtract from the GDP. Because we consistently import more than we export, Net Exports consistently reduce our GDP.
Now, since consumer spending accounts for the large majority of our GDP, it makes sense that the Fed and independent economists should place a large emphasis on this GDP component. In the chart below, we show that over the past seven quarters, consumer spending has been growing at a significantly faster pace than the overall economy. In fact, Personal Consumption has grown by an average of 3.0% over the past seven quarters – well above the average GDP growth of 1.7% over that time frame. In the second quarter of 2016, Personal Consumption grew at a robust pace of 4.2%, nearly matching the best levels since the end of the Great Recession. Clearly there are at least some consumers (read: the rich ones) who are feeling a bit more confident than the Fed.
Source: US Bureau of Economic Analysis.
In the chart below we show overall GDP growth alongside another metric that economists often use – Final Sales to Domestic Purchasers. This metric removes the effects of two components of GDP. The first is Net Exports. If we want to gauge the strength of underlying demand in the US, it would make sense to ignore whether or not we are buying things from domestic suppliers or foreign suppliers. By subtracting the contribution from Net Exports we get a clearer view of domestic demand. Secondly, eliminating the effects of inventory builds or drawdowns can also give us a more accurate picture of underlying demand. The chart below shows that Final Sales to Domestic Purchasers, like Personal Consumption, has been growing at a much faster pace than overall GDP over the past seven quarters (2.5% versus 1.7%). Is the Fed taking this into consideration?
Source: US Bureau of Economic Analysis.
The Fed may indeed defer further interest-rate hikes until 2017. In fact, we think that’s the safest bet at this point. But the GDP figures are not as dire as they appear, and the headline weakness may represent just the latest excuse for a Fed that has backed itself into a corner. Prior to last Friday’s GDP report, the Fed had been worried about the fallout from the Brexit vote. Following the Brexit vote, we heard that Fed officials are beginning to worry about the presidential election uncertainty. The reality is that there will always be excuses to keep the party going. No politician will be criticizing the Fed for failing to raise his/her constituents’ borrowing costs. Raising interest rates is a very unpopular thing to do, especially when you do it preemptively and prior to the onset of big problems.
In my opinion, the biggest threat to the economy at this point is of the Fed’s own making. How, the Fed must be wondering, can we extricate ourselves from seven years of artificially suppressed interest rates and asset price manipulation without causing turmoil in the financial markets? How do we transition back to a world in which markets determine asset prices rather than central banks? How do we prevent a massive spike in the dollar and capital flight from emerging economies if and when we start to raise interest rates in earnest? How do we fight the next recession with such a limited amount of ammunition at our disposal? What do we do if inflation starts to spiral out of control as a result of central bank largesse across the world?
I don’t have all the answers but I hope someone does. I’ll be the first to eat crow if the Fed can pull off this transition without a hitch. But somehow I don’t think that’s in the cards.