Weekly Economic Commentary by Scott J. Brown, Ph.D.
Fun with GDP
May 25 – 29
The current economic expansion is rapidly approaching its six-year anniversary. Contrary to popular belief, the likelihood of entering a recession does not depend on the age of the expansion. However, there are other issues. In this recovery, average growth in the first quarter of the year has been well below the average of the other three quarters, leading to some doubts about the quality of the seasonal adjustment. Looking ahead, the government will introduce two new gauges with the annual benchmark revisions in late July.
Economic activity has strong seasonal patterns related to the weather, the school year, and holiday shopping. Estimates of Gross Domestic Product are adjusted for seasonal differences, or rather, their components are adjusted (usually by the agency providing the source data). By design, seasonally adjusted data should not display signs of seasonal variation (that is, there should be no residual seasonality).
Clearly, first quarter GDP growth in recent years has been lower, but is that truly significant? Economists at the Fed’s Board of Governors say no. Economists at the San Francisco Fed say yes, and properly adjusted, GDP growth for 1Q15 would have been 1.8%, rather than the 0.2% reported in the advance estimate. Yet, any statistician can tell you, five observations are not enough on which to base any meaningful analysis. In other words, nobody knows. Post-recession seasonal patterns may have changed. The housing collapse and mortgage debt overhang could have led to permanent changes in spending habits. Financial deleveraging may have led to longer-term distortions in the credit system. We won’t know for sure until a lot more time has passed. The government does alter the seasonal adjustment over time. However, seasonal adjustment problems will balance out over the course of the year. One can simply look at year-over-year changes.
In Econ 1, students learn the aggregate economic activity can be measured as output or income. While most people are familiar with GDP, may are unaware of GDI. These two measures often differ from quarter to quarter and each has its advocates. In July, the Bureau of Economic Analysis will introduce a new measure, which is simply the average of the two.
Financial market participants place way too much emphasis on the headline GDP growth figure. Consumer spending and business fixed investment are key, accounting for more than 80% of GDP. However, net exports, the change in inventories, and defense spending account for more than their fair share of volatility and can whip the headline GDP growth figure around from quarter to quarter. In July, the BEA will introduce Final Sales to Private Domestic Purchases, which will be a better gauge of underlying demand and be a lot less choppy than GDP.
Questions about the seasonality of GDP growth help highlight the fact that investors should consider the broad range of economic data, not just one figure.
Back to the drawing board
May 18 – 22
The data reports for April suggest that the second quarter’s anticipated rebound from a weak 1Q15 will fall far short of expectations. We could get revisions, figures for May and June could be a lot stronger, but at face value, the economy has disappointed. However, the Fed is still on track to begin raising short-term interest rates later this year. We should come away with a better understanding of how the Fed sees the situation when the central bank’s two top officials speak later this week.
Not all of the news is bad. Weekly claims for unemployment benefits have been trending at a remarkably low level in early May. It’s hard to dismiss the low trend as being due to seasonal adjustment difficulties (which aren’t much of an issue in May). Jobless claims are near at a record low as a percentage of nonfarm payrolls. Yet, job losses really haven’t been an issue in recent years. The real concern is job creation. Recent data suggest that hiring at small and medium-sized firms is still going strong. However, hiring at large firms has slowed to a crawl. The key question is whether that’s temporary.
April consumer price figures will be reported at the end of the week. However, the Producer Price Index and the report on import prices suggest continued disinflationary pressures. There’s very little inflation in “stuff.” Inflation in consumer services is running at a moderate pace. Although there were some supply-chain disruptions related to delays at West Coast ports, manufacturers are generally not seeing the type of bottleneck production pressures that would push inflation higher. Of course, the labor market is the widest channel for inflation pressure. While wage increases have remained relatively lackluster, a decrease in productivity has contributed to an increase in unit labor costs (the labor expense per unit of output). Productivity figures are often erratic and unreliable, but weak productivity growth is a major concern. If firms can’t pass higher unit labor costs along, they will eat into corporate profits. Uncertainties in the productivity outlook, here and abroad, are unlikely to be settled anytime soon.
Where does this leave the Fed? In its April 29 policy statement, the Federal Open Market Committees recognized that the economy slowed in the first quarter, but it pinned that on “transitory factors.” In other words, officials viewed the first quarter softness as temporary. The data reports that have arrived since then (a drop in unit auto sales, soft retail sales, disappointing industrial production, and declining consumer sentiment) point to a subpar pickup for the economy in April and GDP growth in the second quarter is likely to be a lot softer than was anticipated at the time of the Fed policy meeting.
Despite disappointing growth in the first half of the year, Fed officials are still likely to expect conditions that will warrant an initial hike in short-term interest rates later this year. Why would the Fed tighten? The focus is on the job market. We are likely to see more slack taken up in the months ahead. The Fed has to consider where the economy will be 12 to 18 months from now. Monetary policy will still be very accommodative even after the first few rate hikes. There’s no need for the Fed to hit the brakes, but officials do need to take the foot off the gas at some point. Still, Fed officials have emphasized that the pace of tightening after the first rate increase is a lot more important than the timing of the initial move. Fed officials have indicated that that pace will be very gradual.
Later this week, we should gain a lot more insight into how the Fed sees things. Vice Chair Fischer will speak on the euro area on Thursday (some implications for long-term interest rates and exchange rates). On Friday afternoon, Fed Chair Yellen will speak on the economic outlook. Market participants may eye an early exit ahead of a three-day weekend, but Yellen should provide an up-to-date view of how the Fed sees things.
RIP B.B. King – The thrill, indeed, is gone.
In the market’s sweet spot
May 11 – 15
Recent economic data reports have reflected a slowdown in growth, but they are not disastrous. The economy continues to improve, but not so much that the Fed will rush to take away the punch bowl. That’s good news for the financial markets.
Nonfarm payrolls rose about as expected in the initial estimate for April, but figures for the two previous months were revised down. We know that the subpar payroll figure for March was a weather story. The employment report is made up of two separate surveys, one of establishments and one of households. In February, the establishment survey largely missed the major snowstorms, but bad weather hit the March survey period head on. The household survey details showed a larger-than-usual number of people who could not get to work due to the weather. Granted, the employment report’s two surveys are not directly comparable, but they give you a good idea on the weather impact. The April payroll increase largely reflected a rebound from bad weather. The average gain for the two months was 154,000 – a moderate pace.
The unadjusted figures were in line with the usual pattern. The U.S. added 1.178 million jobs in April (before seasonal adjustment), vs. 1.163 million in April 2014. The level of unadjusted payrolls is trending sharply higher relative to a year ago (private-sector jobs are up 2.6% y/y). Still, the underlying trend in seasonally adjusted payrolls has moderated. The ADP estimate shows a sharp slowing in hiring at large firms in March and April, while job gains at small and medium-sized firms have remained relatively strong. This is a contrast to the earlier years of the recovery, when large firms prospered and smaller firms struggled to improve. The gains at small firms are an important signal of a broadening recovery. The softness at larger firms likely reflects the transitional impact of a strong dollar.
For Fed policymakers, the key issue is the amount of slack in the job market. The unemployment rate was 5.4% in April, essentially unchanged from March and down from 6.3% a year ago. However, the employment/population ratio held steady at 59.3%, up only gradually over the last year. Improvement here is more concentrated in the key age cohort (those aged 25-54), but that should broaden to teenagers and young adults over time. Average hourly earnings rose modestly in April, with the year-over-year pace remaining at a lackluster 2.2%. The continued lack of better wage growth is taken as a sign of slack.
The range of recent economic data reports is consistent with a temporary slowdown in growth. The pace should improve as the first quarter’s restraining factors (weather, West Coast port delays, the energy contraction, and the stronger dollar) wane, but some restraints have continued into 2Q15. As a consequence, the 2015 economic outlook appears softer and we’re back to “more of the same.” That is, we’re still on the road to economic recovery. We’ve made a lot of progress, but we’re nowhere near where we need to be. The continuation of this backdrop should be taken well by the financial markets.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
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