GDP growth slows (1/30/2008)

The Commerce Department released the advanced GDP estimate for Q4 of 2007 which detailed a seasonally adjusted 0.6% annual rate of growth. This represents a sharp decline from the Q3 number of 4.9%. The number was also lower than most predictions. Given the propensity for advanced GDP numbers to be revised, up or down, by a full percentage point or more it is too early to determine the full extent of the moderated pace of the economy. These numbers right now indicate growth of 2.2% in 2007, down from 2006 growth of 2.9% and the lowest level since 2002.

More troubling from may be the uptick in inflation. The personal consumption expenditures price index rose 3.9% in Q4, up from the 1.8 increase in Q3. When the more volatile food and energy sectors are excluded the increase is still 2.7%, up from 2.0% in Q3. The chain-weighted GDP deflator rose 2.6%, more than double the Q3 increase of 1.0%.

These inflationary pressures present problems for future Fed policy. Expectations are for a decrease in rates by 25 or 50 basis points today, but any action may disappoint. Markets have already priced in a 50 basis point reduction, so a rate cut of that amount will not likely move markets. Anything less may seriously disappoint and impact markets negatively. Add in the issue of credibility for the Fed as far as responding to financial market risk taking as well as credibility as an inflation fighter and the Fed is between a rock and a hard place.

The current situation indicates less-than-contained acceleration in the price level that could develop into higher inflation expectations in the future. The risk from this would be a sudden and dramatic interest rate reversal by the Fed at some point in the future. We will need to wait and see how markets digest the current macroeconomic data and the Fed's action today.

Fed Rate Cut (1/23/2008)

The Federal Reserve cut the Fed funds rate 75-basis point yesterday. Many people that I talked with are asking, "Who benefits from this cut?" I suggest you think of financial institutions and not financial markets. The recent turmoil at institutions such as Citigroup shows that financial institutions face significant frictions in credit markets. A lower interest rate environment allows these banks to finance new assets and replace nonperforming loans such as subprime mortgages.

The Fed faces several risks after undertaking such a policy. For one, the Fed may now appear captive to stock market concerns rather than the broader economy. Why insulate investors from the risks they knowingly undertook? For this, there is no real answer. Concerns about a larger US recession abound, though there is no consensus yet about whether there will be one or how severe it might be.

Unemployment claims are low and business inventories are not high, both common indicators of recession. True, job growth is slowing, mentioned by the Fed as weakness in labor markets. Overall though, looking at traditional measures, it is not clear we are in a recession.

The effectiveness of rate cuts in the current economic environment are an issue as well. It is likely that such a rate cut will diminish the severity of any recession, though the surge in home inventories makes it unlikely that building activity will respond quickly, and also unlikely that bankers will be willing to expand mortgage lending soon.

The Fed's decision is not being undertaken in a vacuum. There is serious discussion of a fiscal stimulus package from Capitol Hill. The exact size and implementation of the package is not yet decided. The effect of this policy action is uncertain too. Factors such as timing, size of the stimulus, perceptions of business conditions will all play a role in the consumer's response. Add to this the fact that it is a temporary stimulus and there could be no effect, or significant unintended consequences. The testimony of CBO Director Peter Orszag speaks directly to this issue (available on C-SPAN).

A paramount concern must be inflation. If policymakers overplay the downside risks to growth due to equity market concerns they may fashion a recipe for rising inflationary expectations that will force large rate reversals. Obviously the entire situation bears watching.