Monterary Policy: Same As It Ever Was

Last week’s Federal Open Market Committee (FOMC) meeting produced, what may be a first since the U.S. economy went into a recovery; admission by Federal Reserve members that the recovery is coming along more slowly than expected.

That notion was further confirmed by May retail sales numbers, which showed a -0.2 percent decline in spending, all but wiping out the 0.3 percent gain registered in April.   Furthermore, unemployment has essentially been net zero in the first half of 2011 as continuing claims still hover near 3.7 million month after month.

These are items that we are all generally aware of by now, and I am not looking to harp on them.   What is much more important is to take a look at the actions taken by the Federal Reserve and the expected outcomes from those actions.

To do so, I’d like to review a few statements made by Fed Chairman Ben Bernanke and how those beliefs have translated into the economy thus far. 

In November 2002, Bernanke was a member of the Federal Reserve Board of Governors (he was elected Chairman in 2005).  At that time he gave a speech entitled: “Deflation: Making Sure It Doesn’t Happen Here.”  In that speech, Bernanke made a very clear statement that the central bank (Federal Reserve) “should always be able to generate increased nominal spending and inflation even when the short-term nominal rate is zero.”     

So with that being said, when the economy falters the Fed can lower interest rates or increase the money supply or help finance increased government expenditures, etc. in order to stimulate spending and inflation in the economy.  Fundamentally, this is a good thing.

However, we also need to be aware that there is a risk/reward to just about anything economics.  The reward is increased spending and inflation, which spurs economic growth and prevents deflation, which nobody wants to see, trust me.  The risk is that all of these actions don’t spur much of a spending increase and inflation runs stronger than desired, which would only further hurt spending as the cost of everything goes up, thus leading to weaker employment and so on.

In December 2002, Bernanke stated in an interview: “We’ve been very, very clear that we will not allow inflation to rise above 2 percent.”  Now, let’s say inflation did rise above 2 percent, well, than the Fed would just raise interest rates to bring inflation down to an acceptable level.

My two concerns with this are:

The May Consumer Price Index (CPI) reported on June 15 was 0.2 percent, which works out to 2.4 percent annual inflation, so we are above the 2 percent threshold (and have been for several months now).   Yet interest rates still sit a near zero percent and QE2 doesn’t conclude for another week (quantitative easing stimulates inflation, see my earlier newsletters for a full description of this).

Consumer spending is not showing any kind of sustained growth despite all of the Fed’s tools to stimulate the economy.  Monthly spending results have been volatile all year with a strong monthly gain being followed by a decline, not exactly a sign of growing stability.

I’m not going to preach to you in this letter whether the Fed’s actions are right or wrong and if I am worried that inflation is going to get away from the central bank (though I think it’s only a matter of time), but rather display these items so you may stay informed, formulate your own opinion and best adjust your portfolio to weather to outcome. 

Your still staying long inflation safe-haven investments analyst,

Mitch Jaworksi

The GDP numbers received a wonderful massage

Recently, U.S. economic numbers have been disappointing to say the least.  The public, including the market is beginning to act nervously and this doesn’t factor in that data could have even been worse.  What I am referring to is the second estimate of first quarter Gross Domestic Product (GDP), reported at a 1.8 percent annualized rate.

Now, let me explain; GDP is derived by adding Consumption (C) + Investments (I) + Government Spending (G) + (Net Exports).  Any increase/decrease in these factors will drive GDP up or down.  However, what the public eye does not see is what gets calculated behind the scenes, specifically, how the GDP Price Deflator factors into the reported GDP reading.  Below I have listed the definition of the deflator as listed on investopedia.

What Does GDP Price Deflator Mean?
An economic metric that accounts for inflation by converting output measured at current prices into constant-dollar GDP.

A key component of the price deflator is “real” GDP.  Real Gross Domestic Product is the measure of the economy’s output adjusted for price changes, whether inflation of deflation.

The Bureau of Economic Analysis (BEA), which is the unit of the Commerce Department that reports GDP, continued to use a 1.9 percent annualized inflation rate to calculate real GDP.  However, other branches of the commerce department have posted inflation rates higher than that and the April (end of Q1) Consumer Price Index (CPI), which is reported by the BEA, showed that we had year over year inflation of 3.2 percent.

So if we factor in actual first quarter annualized inflation for 2011, rather than the 1.9 percent used, GDP growth shrinks to an annualized rate of 0.55 percent.  Again, it was reported at 1.8 percent.

Hence, the title of this issue.

Also, I’d like to point out some headwinds GDP growth my face in the second half of 2011, especially in regard to the deficit reduction argument.   Looking at the calculation posted above, (G) Government Spending is listed as one of the key components making up GDP.  If government spending is reduced, then it will become a drag on GDP growth going forward, opposed to the boost it has provided through stimulus programs and various other spending programs the past few years.

Since it has become inherently clear Congress will need to cut the deficit, substantially;  granted, some relatively small cuts have recently been agreed upon, but for the most part, this has been argument number one between republicans and democrats. Debates are no longer about "if" but by "how much" the deficit needs to be cut.  Talks have really heated up as the government quickly creeps up on yet another debt ceiling (currently $14.3 trillion).

There really is no need for us to get into numbers here; the government spent more in order to help the economy along as the private sector found its footing from a recession.  Now the private sector, the (P) in the equation will need to pick up in order to offset a slowdown in government spending, which is one of two key facets of deficit reduction.

The other of course is increased tax receipts.  Oh joy!

Your hoping the private sector is recovering as well the government thinks it is analyst,

Mitch Jaworski