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The third estimate of the first-quarter 2014 US GDP rate-based on more complete source data, according to the US Department of Commerce-was reported on June 25 to be -2.9 percent. Current dollar GDP also fell at a 1.7 percent pace. That is a Japan lost decade-style number. And prices rose at only a tepid 1.3 percent pace.
Awful Growth Numbers
These are awful growth numbers (see figure 1), especially given two facts: they are far below forecasts and portend a very weak 2014 US economy, the Federal Reserve’s perennial hope for a second-half recovery notwithstanding. Earlier this year, confident predictions abounded of 3 to 4 percent growth in 2014.
Right up to the initial release of the first-quarter 0.1 percent growth rate in April, forecasters had been calling for a 2.3 percent growth pace. Now, on the third try, the Department of Commerce is telling us that the economy actually shrank in the first quarter at a dismaying 2.9 percent pace. Widespread denial that these numbers imply substantially slower-than-forecasted 2014 growth is setting up the Fed, not to mention markets, for some nasty surprises.
Figure 1. Gross Domestic Product Growth
Source: US Department of Commerce, Bureau of Economic Analysis
Notes: Results are in chained 2009 dollars, at a seasonally adjusted annual rate.
Given the widespread predictions, including those emanating from the Fed, that growth will rebound to a 3 percent pace later this year, growth better rebound quite sharply if we are to avoid a dismayingly weak first half, or a weak 2014 overall. If second-quarter growth “rebounds” to an on-trend 2 percent pace, the average growth rate during the first half of 2014 will be -0.5 percent.
An “official” recession call requires two consecutive quarters of negative growth, but an average growth rate of -0.5 percent during the first half of this year is going to raise talk of recession, especially when it is compared to the expectation last January that growth during the first half of 2014 would be between 3 and 4 percent. The optimistic forecasts were based on a then-much-touted end to fiscal drag. First-quarter weakness has been blamed on the weather, but it pays to remember that it gets cold and snows every winter. That is what seasonal adjustment is for.
All of 2014 is not looking very good, either. If the growth pace during the second half of the year “rebounds” to an above-trend 2.5 percent pace, given a first-quarter -0.5 percent growth pace, the average growth rate for all of 2014 will be a sickly 1 percent. That is far below the much-touted 3 percent pace.
Stop Fussing about “Exit” and Inflation
There is a silver lining to the scary growth numbers. They ought to put to rest current talk about an inflation scare that followed the release of a 2.1 percent year-over-year growth rate for the consumer price index (CPI) in mid-June. Inflation Cassandras at the Fed, in the private sector, and in academia are worried that the Fed will need to start raising interest rates sooner than the currently expected mid-2015 date to prevent a risky “jump” in inflation to 3 percent or higher.
This inflation fussing is nonsense for three reasons. First, it is not going to happen, especially in an economy that is barely growing. Second, there is nothing the Fed can or should do about the recent food-and-energy-driven rise in headline inflation. And third, an inflation rate that stabilizes in the 1.5 to 2.5 percent range would be optimal for a US economy struggling to sustain a subpar growth rate of barely 2 percent as real wages stagnate.
Given virtually zero growth and abundant signs of capacity (see figure 2), the recent modest “jump” in the headline CPI inflation rate will be reversed by fall 2014. During the first quarter, business-fixed investment actually subtracted .27 percentage points from growth. A collapse of inventories subtracted another 1.7 percentage points. Companies that fear weak growth tend to run down inventories, as they did during the first quarter. Net exports subtracted another 1.5 percentage points from growth, while the government sector subtracted 0.14 percentage points.
Figure 2. Total Industry Capacity Utilization Rate
Source: Board of Governors of the Federal Reserve System
Although consumption spending, the typically major source of demand growth, was identified as the source of 3 percentage points of growth when the initial first-quarter GDP growth numbers were reported, consumption spending actually contributed only 0.71 percentage points to growth. The contribution to consumption arising from Obamacare had to be revised down once it was discovered that signups for health insurance did not necessarily transfer into purchases.
Weak wage growth also portends a lack of inflation pressure. Money wages have been rising at a tepid 2 percent pace over the last several years of the “recovery.” With headline inflation at 2.1 percent, real wages are actually falling at a 0.1 percent annual pace. There is virtually no growth of real wages (see figure 3), which in part accounts for the weak demand growth and persistently low inflation that is currently confounding inflation hawks.
Figure 3. Year-over-Year Change in Average Hourly Earnings of All Private Employees
Source: US Department of Labor, Bureau of Labor Statistics
The Fed should ignore, and to its credit has ignored, the recent modest inflation blip. Food prices have been driven up by drought conditions, and energy costs have been boosted by rising tensions in the Middle East. There is nothing the Fed can do about either factor.
Formally, central banks ignore negative supply shocks when setting monetary policy because tightening policy (a negative demand shock) would cause a sharp drop in output and employment if implemented following a negative supply shock arising from a jump in food or energy prices. This danger surfaced in 1974 when, after a sharp jump in energy prices drove up headline CPI, the Fed tightened as part of a “whip inflation now” (WIN) program, only to watch the economy collapse. Policy was quickly reversed. The dismaying WIN episode reinforced the Fed’s use of the core (excluding food and energy prices) personal consumption expenditure (PCE) deflator to set policy.
Core PCE inflation, the best guide to Fed policy, has stabilized at an average level well below the Fed’s 2 percent target. It currently stands at 1.5 percent. If anything, the Fed, along with many households and firms, would like to see core PCE rise a bit closer to 2 percent (see figure 4). That would help reduce real debt loads. Furthermore, firms would welcome the prospect of higher nominal sales revenue that would follow higher inflation, perhaps by enough to increase what has heretofore been a tepid flow of investment. Stated in more formal terms, the fact that US inflation has persistently held below forecasted levels has boosted real wages and real interest rates, contributing to subpar growth of output and employment.
Figure 4. Year-over-Year (YoY) Change in Core Producer Consumption Expenditures (PCE) and CPI
Sources: US Department of Labor, Bureau of Labor Statistics; and US Department of Commerce, Bureau of Economic Analysis
Dangers of Inflation Paranoia
Lessons abound to reinforce the dangers of overreacting to modest inflation increases and of rising fears of inflation increases. The Bank of Japan’s anti-inflation obsession locked the nation into a 15-year period of stagnation after a 1997 tax increase. The European Central Bank’s (ECB’s) current policy, allowing inflation to drop to a 0.5 percent pace (too close to outright deflation and persistent stagnation), has kept Europe’s growth rate at a perilously low 1.1 percent. And that low growth rate is due largely to Germany’s 3.3 percent growth rate. Italy is struggling in a deep recession at a -1.5 percent growth rate, as is much of Southern Europe. French growth is zero. Spain has recently embarked on a program of tax cuts to offset some of the damage arising from the ECB’s obsessive, too-tight monetary stance.
It remains fashionable, imparting a false aura of wise prescience, to rail against the dangers of “runaway inflation.” It is fine to let the inflation Cassandras warn of disasters ahead. Caution is always in order and will eventually be necessary. But it is not fine to heed their current calls for earlier Fed boosts of interest rates. The results of such a surprise move would be, as usual, lower growth of output and employment, not to mention a rising risk of damaging outright deflation.
It is also important to remember that the Fed, for better or worse, has been encouraging businesses and households to take more risk to push up asset prices and enhance wealth and spending. This is all well and good. But if the Fed becomes overly concerned with the specter of possible inflation and acts on that by raising interest rates, asset markets and wealth will drop sharply and the economy will weaken further.
Time to Forget about 3 Percent Growth
It is disconcerting that the Fed has so far said virtually nothing about very weak GDP growth numbers or about its implications for possible changes to policy aimed at sustaining growth. After the June 18 Federal Open Market Committee meeting, Fed Chair Janet Yellen instead chose to look ahead to a growth rebound based on stronger growth of consumption and investment, for which there is yet no evidence. So far, the Fed’s only viable policy option has been to talk about further delaying the first interest rate increase that it mandates. Markets have set that date at about mid-2015. It will no doubt slip further to 2016, given the weakness of the US economy.
At the very least, the Fed needs to stop talking about its exit strategy and when it will start raising interest rates and perhaps start talking about things it might do to boost weak growth. That option would include purchasing a wider range of assets than those currently being purchased under the Fed’s quantitative easing program. But before that happens, the Fed will have to stop dreaming about 3 percent growth and wake up to the reality that 2014 will be a slow growth year wherein a resumption of inflation is not a risk. Given the poor forecasting performance by the Fed and most pundits, perhaps we should remember that deflation remains a risk.
1. See John H. Makin, “Now is the Time to Preempt Delation,” AEI Economic Outlook (April 2014), www.aei.org/outlook/economics/international-economy/now-is-the-time-to-preempt-deflation/.
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