US economic growth figures indicate inflationary dangers and may lead to the “Crime of the Century”

Last week ended with markets again mulling over prospects for this week’s meeting of the Federal Open Markets Committee or FOMC. Just to add to the speculation we received an update on US economic growth. However before I address those figures let me point out that the crucial moment will be at 2:15pm US time on Wednesday the 3rd and all eyes will be on the statement which is released. As only the size of their intervention appears to be in any doubt I will be providing a musical playlist for the rather dull hour before the announcement is made but there is still time for any late suggestions. Also other central banks will be meeting this week as we also get the Royal Bank of Australia, Bank of Japan, Bank of England and European Central Bank. Indeed the Bank of Japan has moved its meeting to this week presumably so it can respond if necessary to any move from the FOMC. Incase it was in any doubt on this issue the Yen closed at an all time closing high versus the US dollar on Friday at 80.39.

US third quarter GDP growth

These have been much debated figures over the past few months but in the event the headline figure was no great surprise as according to the Bureau for Economic Affairs.

Real gross domestic product — the output of goods and services produced by labor and property located in the United States — increased at an annual rate of 2.0 percent in the third quarter of 2010, (that is, from the second quarter to the third quarter),

If we take out the annualisation from these figures then we get a growth rate for the quarter of 0.5% which follows on from a growth rate of 0.4% in the second quarter. If you assume that this half-year of growth was repeated over a year you would get a growth rate of approximately 1.8% which on the fact of it is hardly a disaster. However it is insufficient to reduce US unemployment and if you look at past US recessions then it is slower than what would usually be expected at this point in a recovery.

If one looks at the detail of the report then one does find two disturbing issues in the detail. According to the BEA.

The change in real private inventories added 1.44 percentage points to the third-quarter change in real GDP after adding 0.82 percentage point to the second-quarter change. Private businesses increased inventories $115.5 billion in the third quarter, following increases of $68.8 billion in the second quarter and $44.1 billion in the first.

So an upwards adjustment in inventories contributed 72% of the growth in the third quarter and this followed on from the second quarter where they contributed 51% of the growth. This is significant because there is a limit to how much inventories are likely to grow as companies only build them up in anticipation of future sales. So either we will see an expansion in US demand or the inventory build-up will stop or even worse it may reverse. This build up of inventories is at a historically high level and accordingly also runs the danger of being revised downwards in future revisions. Recent revisions to US growth have tended to be downwards and of the last 6 numbers 5 have been revised downwards.

If one tries to take an optimistic view one might look at something like the contribution of the housing market to the economy as it often performs well in an upturn. There is a measure for this in the figures and it is called Residential Investment but there is no solace from this in the figures as it as a percent of GDP  declined to what is a post war low of 2.22%. As the housing industry helps support many others and is a component of domestic demand which one might hope would demand and use up the inventories which are being stocked we come to a problem.

The problem is that either the third quarters growth will be revised down or the fourth quarter is now looking as if it might be negative.

Comment

So it turns out that a headline number which looks reasonable has components which imply that either it will be revised lower or that swings in the inventory cycle could send the next quarter’s growth negative. So it turns out that the figure has enough uncertainty in it to be used as a justification for the commencement of what has become called QE2 on Wednesday evening. It is not bad enough I feel to justify what might be called full-blown QE2 and I suspect that we will get an expansion of the current QE-lite asset purchases with the Fed. Buying around £100 billion a month. Frankly I do not expect that to do any good at all so if it does start at such a level we will probably see it expanded as soon as we get a sequence of poor economic releases. Let me be clear I am not saying that I think larger purchases will do any real good just that I think that a majority on the FOMC do.

A challenge to the FOMC

If you look at the detail of the GDP report from the BEA you see this.

The price index for gross domestic purchases, which measures prices paid by U.S. residents,
increased 0.8 percent in the third quarter, compared with an increase of 0.1 percent in the second.
Excluding food and energy prices, the price index for gross domestic purchases increased 0.6 percent in
the third quarter, compared with an increase of 0.8 percent in the second.

If you look at the first sentence you might think to yourself that inflation is increasing quite nicely on its own and does not need a boost from the FOMC! For thise who are not regular readers there have been several theories advanced by Fed. members that an increase in the inflation rate should be deliberately engineered as it would, in their opinion, boost the economy. I wrote on the subject of US inflation indices on the 2nd of July where I argued that the American Consumer Price Index is a very poor measure of inflation and if you compare its recent readings to that of the GDP deflator here I think you find another illustration of my point.

A Technical Issue

I often ask for readers to stop and think for a second. Last week an auction of US inflation-proofed bonds took place and they took place at a negative real interest rate. So if there was no inflation they would lose money if they held to redemption. I find this interesting because these securities or TIPS are based on a poor measure of inflation or US CPI, yet still there was demand sufficient to send real rates negative. It means to me that I am a long way away from the only person worried about inflation prospects. I see plenty of talk in the media on the subject but I find it more revealing sometimes to see what actually happens with investors money….

Inflation in the UK

There have been a couple of developments over the past few days which continue themes that I have been discussing in this blog for some time. For example the duty or tax on airline flights has today risen by up to 55%. According to the BBC  a flight to Australia will now have a flight duty of £85 up from £55 and one to the US will rise from £45 to £60 so the theme of tax rises or official price rises leading to increases in inflation continues.

My next point is slightly more subtle and I doubt if the official indices catch it. In the UK utility companies have tending to raise gas and electricity prices for the winter season but cut them for summer. The company SSE has recently raised its gas tariffs by some 9.4% to reinforce this trend. My point is that say they do this for 6 months of the year then cut them one might think that nothing has changed. Unfortunately for the poor consumer they end up paying higher prices in the months of highest consumption and in a cold winter like the last one use would be massively skewed towards the winter months. In effect this is inflationary.

We have also had strong economic growth figures for the last 2 quarters and this morning I see that UK manufacturing is supposed to have been strong in October too according to a survey, so perhaps now is not the best time to say the least for more asset purchases in the UK. However as I reported last week it would appear that the housing market is turning downwards with Hometrack this morning reporting a fall in house prices of 0.9% last month.

Conclusion

It would appear that the United States will see more asset purchases by its central bank on Wednesday but the UK will not see anything similar on Thursday. Indeed if you take recent UK evidence then there should be a swing towards the position of Andrew Sentence who argues for a small interest-rate rise.

I have pointed out before that the existence of QE1 should be a salutary lesson to those who feel that QE2 will succeed or even achieve much at all. Yu have the immediate issue of explaining why more of something is better when it is not clear the initial intervention worked.Today I merely wish to point out the danger of apparently trying to boost inflation when according to the latest GDP figures it seems to be on a rising trend anyway.From the BEA again.

The price index for gross domestic purchases, which measures prices paid by U.S. residents,
increased 0.8 percent in the third quarter, compared with an increase of 0.1 percent in the second.

Those on a fixed-income or who take out an annuity

Such individual’s are in danger of having severe damage done to their finances by what looks like will be official US policy. I have written on this subject in the past but when a central bank actually aims to increase inflation we are in an unusual situation to say the least. Plainly an increase in inflation will hurt those on fixed incomes as the real value of their income will be affected.

Indeed inflation will hit savers hard as another version of policy in both the UK and US is to keep official interest rates low to try to boost the economy. This means that the interest rate on savings is low too which combines somewhat uncomfortably with potentially higher inflation and unlike Monetary Policy Committee member Adam Posen I feel that a high of 3.6% for UK CPI is a problem as it means our old and more accurate measure is over 5%. Perhaps it seems low from the comfort of an index-linked salary and pension.

However my sympathy mostly goes to annuitants at this time. They face what are low long-term interest rates and inflationary dangers just at a time they may be choosing to commit themselves to a decision which may commit them for 20 or 30 years. Adam Posen’s “low” inflation would punish them severely over such a timescale. In fact under virtually any scenario apart from economic collapse they look poor value to me and under many scenario’s I think are likely they look investments which in other circumstances might have the label of “miss-selling” applied to them. I wish to be clear that this is my opinion and is not investment advice.

Indeed as I am looking for musical themes for Thursday here is a musical theme for those in the position I have just described. They may look back and think that “Crime of the Century” by Supertramp is/was appropriate.

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7 thoughts on “US economic growth figures indicate inflationary dangers and may lead to the “Crime of the Century”

  1. Theme for the Fed’s QE announcement: Wagner’s “Ride of the Valkyries” – think of the famous scene from Apocalypse Now – Kilgore’s helicopter assault on the beach.

    I agree that QE2 looks like a done deal (probably in the UK as well sadly), and that it will not have the desired effect of boosting growth. However, I often wonder whether this is really incompetence on the part of the Fed and BoE, or whether they have another agenda, i.e. ‘financial stability’. Lots of people argue that they are simply trying to default by printing money, but I am not so sure (unless you believe the assets will be held till maturity and purchases will continue indefinitely). What sort of assets do you expect the Fed to buy? This, and the spending decisions of the US government, will have implications at least as important as the size of the purchases. Finally, could Bernanke be removed before the end of his term by the new congress if they believe his actions are not in America’s best interests?

    • Hi Graeme

      To answer your questions I believe that the first is the easiest. This time around the Fed. will mostly if not entirely buy US Treasuries with its money. It may also buy some private-sector assets but it would be wise to steer clear of mortgage related ones on the grounds that it already has a lot of them on its balance sheet and with foreclosuregate questioning their value buying more would be very unwise..

      As to the second this is much harder. The President of the USA appoints Governors of the Fed to fourteen year terms. I guess the only possible route would be for the House of Representatives to impeach the Fed. for something such as conspiracy. Imagine the chaos that would cause on its own.

  2. I agree with graeme_b and would add that you should now factor in the recommendations of the National Commission on Fiscal Responsibility and Reform which, together with Mid Term successes for Teapartyers, could lead to the mother-of-all fiscal consolidations eating in to US govt discretionary spending.I dont think the grass-roots are going to stomach tax hikes of unprecedented proportions. The Defence budget is already being eyed up by members for major cuts, involving huge numbers of contractors.

    Think for a moment how Bernanke hopes to offset these dynamics with artificial liquidity production? The Fed’s balance sheet may then need to deleverage at a time not of the Fed’s choosing

    • What do you think would force the Fed to shrink its balance sheet? Do you envisage operating losses, sustained by marking asset purchases to market, would force them to do this?

      In the short term though, a serious fiscal retrenchment would surely be deflationary, and would support the price of investment grade debt (which presumably describes the bulk of the assets the Fed acquired during QE1?)

    • Hi Shire
      I agree that we await the election results in the US to see how the land then lies in the Senate and the House of Representatives. It looks likely that the Republicans will gain ground but there is only one poll which counts. Also we may see more radical Republicans elected aka the Tea Party.

      Until then we do not know the implications one of which could be a type of gridlock with a lame duck President which would make Bernanke’s job ever more difficult…

  3. I expect to see QE2 from the BoE but this time going on mortgages and other private sector debt. If housing heads south then so do the banks and the whole point of the bail out was to prevent assets from falling in price.
    The only agenda is to raise inflation so the general price level rises to meet assets.

    • A sad situation, gloves off time and absolutely no attempt to appear the saviour of the British people, the Bank of England will attempt another bout of grand larceny in the middle of rising inflation, just to get themselves and their banking chums off the hook, all at the expense of the average man in the street.

      Whether it is to be private assets in the form of dud mortgages or Treasuries because nobody else wants them, the real subscriber will be the guy with a positive balance at the bank whose balance will be slowly eroded by the new money being introduced.

      Neither the Fed nor the Bank of England now make noises about reversing their fraud because both by now know the monster they have created is too big to control.

      The governments have made it clear that it is a game of them and us and so we must head to the hills and buy gold. Their paper money was never more than a thinly disguised sham anyway.

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