Friday, October 26, 2012

Quick thoughts on GDP: more stagflation

Third quarter real GDP growth was a bit stronger than expected (2.0% vs. 1.8%), but to me that was not the big news of the day. The more significant "beat" in the data was the GDP deflator, which came in at 2.9% vs. expectations of 2.1%. The combination of the two pushed nominal growth (on a quarterly annualized basis) up from 2.8% in the second quarter to 5.0% in the third quarter. With the exception of only 3 of the 13 quarters since the recovery began, nominal GDP growth has been 4% or better. We are a long way from facing any threat of deflation, and it should be abundantly clear that there is no shortage of money.

From a long-term perspective, this continues to be the weakest recovery ever. As the chart above suggests, the economy is about 13% smaller than it could have been absent the deep recession and the very meager recovery. That is equivalent to a little over $2 trillion of national income that has gone missing, and that accounts for at least half the size of the current federal deficit. In other words, the tax base on which current tax rates are applied is a lot smaller than it could have been. 

The chart above shows the quarterly annualized rate of inflation according to the GDP deflator. The economy flirted only briefly with inflation late last year and in the second quarter of 2009, but other than that it looks like inflation is on track to be 2-3% going forward. This casts further doubt on the Fed's commitment to keep inflation low, since currently they are pursuing an obviously reflationary strategy at a time when inflation is at or above their target. It's not difficult to conclude that they are giving much greater weight to their full employment target at the expense of their inflation target.

This new inflation reality also clashes head-on with the yields on Treasuries. 5-yr yields are a measly 0.8%, 10-yr yields are a paltry 1.8%, and 30-yr yields are 2.9%. Negative real yields on everything out to 10 years mean that savers are being cheated and borrowers and speculators are being rewarded. The incentive to save is low and the incentive to speculate is high, and that is not a prescription for healthy economic growth. Erratic and inflationary monetary policy thus gets some of the blame for the slow growth of recent years. I worry that if the Fed keeps short-term rates close to zero for the next few years, as they promise, we could face a serious inflation problem in the next 3-5 years.


Buddy R Pacifico said...

" The incentive to save is low and the incentive to speculate is high, and that is not a prescription for healthy economic growth."

Maybe the Congressional mandate for the Fed should be to incentivize investments and stablalize money growth.

Public Library said...

Great summary + conclusion. Maybe the market is pricing in the risk of another mishap from the Fed already. As you suggest, the longer the price distortions go on, the higher the probability of a major error in 3-5 years’ time. It took 8 years to produce another bust after the 2001 tech bubble. We are 4 years into what is definitely another misallocation of money and credit. Question is where and when will the bust occur.

Scott Grannis said...

Buddy: I would put it slightly differently: The Fed's mandate should be to pursue price stability, since that is the best way to incentivize investments and achieve low unemployment and rising living standards.

The key, of course, is what method they use to achieve price stability. The current method, which involves targeting short-term interest rates, has not done a very good job of stabilizing prices or creating strong growth, and is subject to political pressures. Increasingly, it's looking like the Fed should be following some variant of a gold standard, which has the virtue of eliminating the Fed's ability to use discretion. Humans are fallible.

Public Library said...

Scott that is a fantastic idea. Some argue Germany has a golden opportunity to 1) exit the Euro while they are in decent shape, and 2) back their currency with gold. Their central bank is known for its hawkish stance given its history. The combination of gold + a strong central bank would provide a potent combination and possibly the next reserve currency of the world. It is difficult to understand why Germany wants to tie its fortunes to some of the more socialist countries in their union. They should seize the moment now.

steve said...

just a matter of time before the poop hits the fan due to a fed that insists on playing god with artificially low rates and other shenanigans. what puzzles me is why scott and others are so bullish given this backdrop. surely the main reason behind the resurgence of RE and other assets has been low interest rates. I just cannot make myself believe that fed manipulation can build a foundation worth anything than short term speculation.

Public Library said...

Out of the IMF working paper: The Chicago Plan Revisited

"At the height of the Great Depression a number of leading U.S. economists advanced a
proposal for monetary reform that became known as the Chicago Plan. It envisaged the
separation of the monetary and credit functions of the banking system, by requiring 100%
reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this
plan: (1) Much better control of a major source of business cycle fluctuations, sudden
increases and contractions of bank credit and of the supply of bank-created money.
(2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt.
(4) Dramatic reduction of private debt, as money creation no longer requires simultaneous
debt creation. We study these claims by embedding a comprehensive and carefully calibrated
model of the banking system in a DSGE model of the U.S. economy. We find support for all
four of Fisher's claims. Furthermore, output gains approach 10 percent, and steady state
inflation can drop to zero without posing problems for the conduct of monetary policy."

djakel said...

There is another country that has been buying up tonnes of gold in the last 3 years. China. When they accumulate enough (3-8 years), they will back their currency with gold and challenge the U.S. to do the same or lose reserve currency status. A pre-emptive strike of backing the dollar with gold would also be our best strategy for enforcing discipline on Congress.

William said...


A measure of future U.S. economic expansion edged up last week, though the annualized growth rate declined for the first time since June.
The Economic Cycle Research Institute said its Weekly Leading Index gained slightly to 126.8 in the week ended Oct. 19 from 126.6 the previous week.

The index's annualized growth rate slipped to 6.0 percent from 6.1 percent.

William said...

LIPPER US Fund Flows

Monthly September
Equity Fund Inflows $7.8 Bil; Taxable Bond Fund Inflows $34.3 Bil
xETFs - Equity Fund Outflows -$17.3 Bil;
Taxable Bond Fund Inflows $31.8 Bil

Quarterly Q3
Equity Fund Inflows $2.6 Bil; Taxable Bond Fund Inflows $87.9 Bil
xETFs - Equity Fund Outflows -$40.8 Bil;
Taxable Bond Fund Inflows $79.4 Bil

As I recall Total Equity Fund Outflows for August were $13+ Billion

William said...

Schaeffers Investors Intelligence

This is the opinion of investment news letters.


Scott Grannis said...

djakel: Re China buying up gold and turning the yuan into the premiere gold-backed reserve currency. The one problem with this as I see it is that the Chinese are buying gold at extremely elevated levels. This smacks of classic bureaucratic thinking, which always reacts to events rather than being proactive. The time to accumulate gold was 10 years ago, not today when it is almost three times higher than its historic average in real terms. Thinking themselves brilliant, the Chinese could conceivably be buying gold at the top tick. If they subsequently tied the yuan to gold and gold fell, they could face tremendous deflationary pressures. In any event, it's far from a slam-dunk strategy to execute.

JordanRB said...

Gold is in a major bull market and is going way higher. No one owns gold nor gold stocks even 13 years into this bull market. Ownership is about 1-2% of global capital. The global sovereign debt crisis is only going to get worse and money printing will be the order of the day in the coming years.

NormanB said...

We aren't ever going to fill that potential GDP gap. Why? Our changing demographs.

Over the last 20 years percentage of white and Asian population in the US has been declining while the black and hispanic part has been growing. The cause for the GDP gap then will be the productivity disparity between these two groups.

It is easily seen in education attainment. Only 10% of young black and hispanic males in the 8th grade can even read and do math at a proficient level.

The 20 year deficit in the white population has been about 9 percentage points. Subtract out that from the productive segment and add in a tiny bit for the growth of blacks and hispanics (but surely their high incarcineration rate will be a subtraction, also) and you come out with our long term real GDP growth of 3% to 3.5% as being only an historical memory. (A better person could come up with some solid numbers on this.)

The sad part of this is that this trend is not stopping. Neither are blacks and hispanics declining in population nor increasing their educational achievements. The white population's birth rate is declining on top of it all.

Rein in your long term GDP growth models.