Friday, October 29, 2010
I'm going to leave it to others to tear apart the Q3 GDP number (which was a bit disappointing) and focus instead on where GDP is headed, from a top-down perspective. Quarterly GDP numbers aren't very useful, in any event, since they are old news by the time the first estimate comes out, and then they are subject to multiple revisions. The point of paying attention to the economy is to know where it's likely to go in the future, not where it's been.
Let's start with money. The M2 measure of money is arguably the best (and it's my long-time favorite): it is published weekly with only a minor lag, it's subject to only minor revisions, its definition hasn't changed materially over the years, and it's displayed the most stable relationship to nominal GDP over long periods of any measure of money.
This first chart shows M2 velocity, which is nominal GDP divided by M2. The inverse of this measure is money demand: how much of a year's spending the economy wants to hold, on average, in the form of currency, checking accounts, retail money market funds, small time deposits, and savings deposits. Note that, as the chart above shows, for the past 50 years M2 velocity has been virtually unchanged on balance, though it has oscillated up and down in the intervening years.
The big story behind the economy's collapse in 2008 was a huge surge in money demand (i.e., a huge decline in money velocity). People thought the end of the world was approaching, and so they stopped spending and started hoarding cash; the demand for money surged, and money velocity collapsed. The velocity of M2 fell almost 13% from the end of 2007 through mid-2009, the largest decline in velocity on record. This process has been partially reversed since the economy started growing in mid-2009, as M2 velocity has risen 1.9%. Confidence is slowly returning, and people are beginning to un-hoard some of their cash. Nevertheless, the revival of M2 velocity is still in its infancy.
M2 velocity only fell modestly in Q3/10, as nominal GDP grew at a 4.4% annualized rate and M2 grew at a 5.0% annualized rate. I suspect that it will be trending higher over the next several quarters as confidence continues to build, but let's assume that velocity is unchanged in the current quarter. With M2 currently growing at a 7% annualized rate over the past six months, and at a 8% rate over the past 3 months, we could reasonably expect M2 to rise at least 6% (annualized) in the current quarter. If it does, and velocity remains stable, that would imply a 6% nominal rate of growth for GDP in Q4/10. Of course, if velocity picks up, then nominal GDP could grow even more. Furthermore, if inflation in the current quarter remains at the 2% pace of Q3, then we could see real GDP growth in Q4/10 of 4% or more.
As one commenter mentioned earlier today, we would need to see at least 4.5% real growth in the fourth quarter in order for real growth to equal or exceed 3% for all of 2010. I don't think that's unrealistic at all. I know there are a lot of assumptions behind this forecast, but I don't think I've made any that are unreasonable, so I'm sticking with my call for 3-4% growth for the current year and for the average of the next several quarters. If I'm wrong it won't be by much. And given the market's penchant for seeing a double-dip recession around every corner, even if growth this year comes in at 2.5% that will be more than what I think the market expected to see.
In this last chart I've plotted the level of real GDP against a 3% trend. This gives us a proxy for what the so-called "output gap" might be, which I estimate to be about 7-8%. Growth has to exceed 3% for the output gap to close, and until it begins closing we are unlikely to see any meaningful reduction in the unemployment rate.
I think it's possible for growth to exceed 3%, especially in the wake of next week's elections. I firmly believe the elections will have a powerful influence on the course of fiscal policy, since they will send a clear mandate to Washington to a) slow the growth of government, b) roll back ObamaCare, c) keep cap-and-trade on hold, and d) extend the Bush tax cuts. This will result in a much-needed business confidence boost, which in turn should unleash at least a mini-surge in new investment and new jobs, not to mention a boost to M2 velocity.
If there is a dark cloud in this otherwise bright forecast, it is that inflation pressures are likely to gradually build, since the Fed—with its Phillips Curve/output gap mentality—is likely to be slow to respond to signs of an improving economy. But inflation concerns will be relegated to second place for at least awhile, while markets breath a sigh of relief.
Posted by Scott Grannis at 2:29 PM