The soft landing the Fed believes in may just be a fairy tale

The real value of the GDP data lies in what it implies about what will happen in the coming quarter.

The U.S. economy has something in common with Major League Baseball’s World Series, which kicks off Oct. 27. The game pits two good-but-not-great teams, the Texas Rangers and the Arizona Diamondbacks, against each other, with each team earning a ticket to the World Series by winning their respective league titles through the playoffs.

The performance of the initial GDP of the United States in the third quarter can be described as "not bad", but not "very good". The growth rate of 4.9% exceeded the general forecast of economists and was more than double the growth rate of 2.1% in the second quarter. Economists had previously expected the GDP growth rate in the third quarter to be between 4% and 4.3%.

However, some of the factors that boosted the third quarter data may no longer contribute to GDP, and some factors may be deducted from the GDP calculation. In addition, the data show that the probability of the Federal Open Market Committee (FOMC) keeping interest rates unchanged when it meets this week is very high, while inflation remains well above the 2% target. If the Fed does not make substantial further progress towards this goal, the logical choice will be to raise interest rates rather than cut them in 2024 as the market expects.

More than half of the third-quarter growth came from consumer spending, which accounted for 2.7 percentage points of the 4.9% increase, according to analysis by Macquarie North America economists David Doyle and Neil Shankar.

Americans spent money primarily on experiences, such as concerts by Taylor Swift and Beyoncé, travel, hotels and, of course, goods. But the economists noted that consumers were dipping into their savings for such spending, as data showed that real discretionary spending had contracted for three straight months through August.

Residential construction contributed just 0.1 percentage point to GDP in the third quarter, while nonresidential business investment contributed zero, the lowest contribution since the third quarter of 2021, and government spending contributed 0.8 percentage point, and together these components make up final domestic sales, which account for a total of 3.6 percentage points. Another 1.3 percentage points came from inventory accumulation, while 0.1 percentage point was subtracted from the trade balance for rounding.

The point is that while 4.9% growth is "very good," 3.6% domestic final sales growth, excluding inventory and trade fluctuations, is merely "okay."

Steven Blitz, chief U.S. economist at TS Lombard, pointed out that the real value of the GDP data lies in what it implies about what will happen in the next quarter. Blitz expects that the annualized growth rate of U.S. GDP will slow to 1.5% in the fourth quarter as the boost from fiscal policy fades and the impact of the Fed's interest rate hikes begins to take effect.

Nominal GDP, unadjusted for inflation, grew at an annualized rate of 8.5% in the third quarter, including a 3.5% increase in the GDP deflator. If measured from a year ago, nominal GDP growth is still a high 6.3%.

Joseph Carson, former chief economist at AllianceBernstein, noted that given that nominal GDP is growing at its fastest pace since the mid-1980s, the Fed should consider further raising its policy rate. “History shows that only a federal funds rate equal to or above nominal GDP growth can slow economic growth, and the current interest rate target is still 0.75 percentage points below year-over-year GDP growth,” Carson wrote on LinkedIn.

Given the current growth rate of the U.S. economy and the Fed's goal of reducing inflation, a more appropriate interest rate policy should be the interest rate policy implemented from the mid-1980s to the mid-1990s, when interest rates were kept at the same or higher level than nominal GDP.

By contrast, during the inflationary period of the late 1960s and 1970s, interest rates were consistently below nominal GDP, Martin Barnes, former chief economist at BCA Research, wrote in the November Bank Credit Analyst.

The anti-inflation era began when Paul Volcker was appointed chairman of the Federal Reserve in 1979. By the end of 1980, the Fed had raised the federal funds rate to 22%, well above the inflation rate of 12.4%, which led to a severe recession but also kicked off a decades-long anti-inflation period.

That changed after what Barnes calls the “Great Financial Recession” of 2007 to 2020. The Fed kept short-term interest rates at zero from 2010 to 2015, while nominal GDP growth averaged 4%. But inflation remained surprisingly low as growth was more modest and workers’ concerns about job security kept a lid on upward pressure on wages.

“Central banks talk tough about getting inflation back to 2%, but actual actions matter more, especially if economic growth is better than expected,” Barnes wrote.

Barnes pointed out that the Fed's forecast of a soft landing of the U.S. economy in 2024, a median inflation forecast of 2.2% in 2025, a real GDP growth rate of 1.8%, and a federal funds rate of 3.8% are all "fairy tale endings." He believes that the Fed may have to adjust its inflation target and eventually tolerate an inflation target of 3% to 4%.

A moderate rise in inflation may be a good thing for some countries, especially those with heavily indebted governments, which would be happy to see a reduction in their actual debt burden. But Barnes believes that the bond market and the public will not tolerate inflation rates exceeding 5% because it will cause the real returns of long-term government bonds to fall sharply or even to zero. "From an investment perspective, I prefer to hold short-term fixed-income assets until economic risks subside," Barnes said.