Business

Thursday’s GDP Report May Hold Big Surprises

Thursday’s GDP Report May Hold Big Surprises by Gary D. Halbert

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert

July 28, 2015

IN THIS ISSUE:

  1. Chair Yellen All But Promises Rate Hike This Year
  2. Why is the Fed So Preoccupied With Raising Rates?
  3. Thursday’s 2Q GDP Report Could Be a Surprise
  4. Annual GDP Revisions Could Give Fed Green Light

Overview

The next few days should be an interesting time in the markets. The Fed Open Market Committee (FOMC) is meeting today and tomorrow and will release its latest policy statement at the conclusion of the meeting. While it is not expected that the Committee will vote to raise the Fed Funds rate at tomorrow’s meeting, Fed Chair Janet Yellen has been talking hawkishly about a rate hike of late.

Friends, business associates and clients increasingly ask me: Why is the Fed so intent on raising interest rates? The US economy is not that great, the global economy is slowing down, inflation is practically nonexistent and com modity prices are signaling deflation. So why on earth is the Fed hell-bent on raising rates when much of the world is doing just the opposite? I’ll tell you why as we go along today.

Then on Thursday, we get the first estimate of 2Q GDP from the Commerce Department, and there is an unusually wide range of pre-report estimates. While there is broad agreement that the economy bounced back after the disappointing 1Q rate of -0.2%, some forecasters believe the 2Q estimate will be less than 1%, while others believe it will be north of 3%. That’s a huge spread! The Atlanta Fed’s rolling “GDPNow” indicates 2Q growth of 2.4%.

Yet perhaps the most important news of this week will be the Commerce Department’s annual revisions to its GDP numbers going back several years on Thursday. While such revisions happen every year, this year’s revisions and changes are expected to be more significant than usual as the government tries to smooth-out “seasonal adjustments.” Many expect that the 1Q GDP estimate of -0.2% could be revised to a slightly positive number. This will be big news.

Chair Yellen All But Promises Rate Hike This Year

Janet Yellen has been in the spotlight a lot this month. She gave a policy speech at The City Club of Cleveland on July 10, and then testified before the House of Representatives and the Senate on July 15 and 16. As noted above, the FOMC is meeting today and tomorrow, although this meeting does not include a Yellen press conference afterward.

The FOMC meets eight times a year, typically about every six weeks. Of the eight meetings, four are followed by a press conference with the Chairman, or the “Chair” as Yellen requested to be addressed when she took the helm last year.

Of course, the question on everyone’s mind is when will the Fed announce the first Fed Funds rate hike since 2006? In Cleveland, Ms. Yellen said:

“I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term…

I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step…

We are close to where we want to be, and we now think that the economy cannot only tolerate but needs higher interest rates.”

Most Fed-watchers still believe the most likely time for the first rate hike, or liftoff as it’s called, will be at the September 16-17 FOMC meeting, which is the next time for a scheduled post-meeting press conference with Ms. Yellen.  The assumption has been that the Fed would not raise rates at an FOMC policy meeting that did not include a Yellen press conference afterward to explain the reasoning.

However, Yellen cast some doubt on that assumption in her recent congressional testimony. In answer to a question, she reportedly replied that the first rate hike could come at virtually any upcoming FOMC meeting – regardless of whether a post-meeting press conference was scheduled or not – if the economy continues to improve.

In fact, this issue was actually discussed by the Committee at the March 17-18 meeting when it noted that if the first rate hike occurs in a non-press conference meeting, Ms. Yellen could call a special press conference to discuss the decision.

Why is the Fed So Preoccupied With Raising Rates?

The question I am increasingly asked is, Why is the Fed so hell-bent on raising interest rates? The US economy is not that great, the global economy isn’t either, inflation is practically nonexistent and commodity prices are signaling deflation. So why on earth is the Fed so intent on raising rates when much of the world is doing just the opposite?

There are several reasons. First, the Fed’s economic assumptions have been too optimistic for the last several years and, as such, it has been preoccupied with inflation coming back – which hasn’t happened.

The Fed’s favorite measure of price inflation is the Personal Consumption Expenditures Index (PCE) which is published monthly by the Commerce Department’s Bureau of Economic Analysis.  For the 12 months ended May, the PCE rose only 0.22%, which is a long way from the Fed’s target of 2%. Excluding food and energy, the PCE is only up 1.24% year over year. As you can see, the trend is still going in the wrong direction, at least from the Fed’s standpoint.

GDP Report

Second, the Fed has a long history of being late to take action, going all the way back to the Great Depression.  Yellen, like her predecessor Ben Bernanke, believes that a near-zero Fed Funds rate is simply not normal and is anxious to “normalize” it. In the quote above, Yellen says the economy “needs higher interest rates,” but she did not say why.

There are plenty of theories as to why the Fed is so preoccupied with raising rates. But I believe it all boils down to this: The Fed is intent on raising rates in order to reload for the next recession. The Fed feels desperate to lift the Fed Funds rate several notches higher as soon as possible in order to be able to lower it again when the next recession comes along.

The problem is the current economic recovery is so feeble that Fed rate hikes could actually be the spark of a new recession. This explains in large part why the Fed has held off as long as it has. But as Yellen has expressed in recent weeks, she and most of her colleagues feel that the time has come to get started. My guess remains that we’ll see a modest rate hike in September.

Then the question is, how much? Here, too, theories abound. While it fluctuates daily, the Fed Funds rate has averaged around 0.13% in July. Most Fed watchers agree that the first rate hike will be only 25 basis points, thus raising the rate to around 0.38%. Others believe it could be raised