• Fed in watch-and-wait mode

  • U.S. economy remains resilient

The Federal Open Market Committee (FOMC) today held unchanged its current asset purchase program of $85 billion per month. The Federal Reserve avoided providing new nuances to existing forward guidance and re-issued the June policy statement with minor modifications to reflect recent economic developments.

President Esther George of the Kansas City Fed dissented once again, as she continues to remain concerned about “financial imbalances” and “an increase in inflation expectations” that may result from continued purchases of assets. President James Bullard of the St. Louis Fed voted with the majority but had dissented in June, as he viewed low inflation readings as worrisome.

The Fed continues to believe business activity will pick up from its recent “modest” pace. The Fed noted that it “recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipated that inflation will move back toward its objective over the medium term.” Inflation readings in today’s second quarter U.S. gross domestic product (GDP) report show continued deceleration (see chart, below).

Flexibility to reduce or increase asset purchases depending on economic conditions remains embedded in the policy statement. The optimism about future trends of output and inflation continues to convey the Fed’s confident view. The main implication is that the FOMC has not changed its mind about tapering asset purchases in the months ahead, but today’s statement failed to pin down the precise time when tapering would commence.

Takeaways from GDP Report

There is a lot to digest from today’s report on the economy – growth of real GDP in the second quarter, the impact of fiscal consolidation and the weak economic situation abroad, plus benchmark revisions that the Commerce Department undertakes about once in five years.

Real GDP grew at an annual rate of 1.7% in the second quarter after a 1.1% increase in the first quarter. The headline was better than expected. Among the major components, consumer spending advanced 1.8% versus a 2.3% increase in the first quarter, inventories added to GDP, non-residential fixed investment moved up 4.6% and residential investment expenditures maintained a solid path (+13.4%).

Federal government spending declined 1.5% in the second quarter, reflecting a 3.2% drop in non-defense spending and nearly stable defense outlays; on net, sequestration had a modest adverse impact. Surprisingly, state and local government spending rose 0.3%, the second quarterly gain since late-2009.

Economic Update July 31, 2013, Chart 1 image

Exports gained momentum (+5.4%) in the second quarter after slipping in the first quarter. The probability of this strength prevailing in the next quarter is low, given the shaky economic fundamentals of major trading partners of the United States.

The personal consumption expenditure price indexes, overall and core, posted year-over-year gains of 1.1% and 1.2%, respectively. They remain below the Fed’s 2.0% inflation target.

The benchmark revisions going back to 1929 include improvements and statistical changes. The most important change is the reclassification of intangibles asset expenditures as investment spending, with research and development as the largest item. The size of the U.S. economy is now larger than previously estimated, but growth rates matter more than levels of GDP.

The Commerce Department estimates that average annual growth of real GDP was 3.3% for 1929 – 2012, 0.1 percentage point higher than previously estimated. For the period of the Great Recession, GDP declined at an average annual rate of 2.9%, a bit more shallow than the 3.2% drop estimated earlier. For the period of expansion from the second quarter of 2009 to the first quarter of 2013, real GDP rose at an average annual rate of 2.2%, barely different from the 2.1% increase published earlier.

Coming back to Fed policy, the Fed’s projected 2013 GDP of between 2.3% and 2.6% stands a good chance of revision at the September FOMC meeting, as this forecast now implies significantly stronger growth in the second half of 2013 following a 1.4% increase in GDP in the first two quarters of the year.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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