Better-than-expected GDP kills the Fed’s pessimistic 2.0 pivot

Federal Reserve Building, the headquarters of the Federal Reserve Bank.

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The US economy remains strong, with a real GDP growth rate of 2.6%. Real GDP growth returned to the positive trend, as the GDP price index was lower than expected, coming in at 4.1%. However, it should be noted that nominal economic growth has also remained very good, with Nominal GDP is growing at 6.7% on a seasonally adjusted annual rate. That growth rate is still slightly faster than the first-quarter nominal growth rate of 6.6%.

It’s hard to say at this point that the Fed has made much progress in pushing economic growth below trend. Yes, there is a delay of six to nine months for monetary policy changes to hit the economy. However, at this point, nominal GDP growth is rising at a rate above the historical average since 2001 of 4.4% nominal growth.

nominal GDP growth

Bloomberg

Prices rise with nominal growth

The chart below shows that the GDP price index tends to rise during periods of high nominal growth, and when nominal growth decreases, the GDP price index falls. Although the price index fell in the third quarter, it is likely to be revised, and this revision may be higher because it was well below expectations of 5.3%. In addition, nominal growth will need to continue declining for this price index to decline.

GDP price index

Bloomberg

The Fed won’t be able to pivot or halt interest rate hikes anytime soon. Much of the nominal growth still has to be removed from the economy, which is likely to take higher interest rates.

The dollar is worried

In addition, the dollar is an important factor here for the Federal Reserve as a strong dollar helps reduce costs not only for goods but also imports. The dollar strengthened materially against the yen, euro and Chinese yuan. The yuan depreciated against the dollar only in the third quarter, rising from 6.71 to 7.23. An appreciation of the value is an indication of the depreciation of the Chinese currency.

Chinese currency devaluation

Bloomberg

It seems likely that once the market believes that the Fed will start to undo the rallies or there is a pause coming, the dollar will move materially lower, helping to push commodity and import prices higher. That wouldn’t be good for the Fed.

DXY chart

Bloomberg

Also, the weakness of the dollar would ease financial conditions, and easing financial conditions would help inflate asset prices. Rising asset prices, such as stocks, will again create a wealth effect and will not be good for the Fed’s mission if it hopes to meet its 2% target.

Financial Terms - SPX Index

Bloomberg

PCE tomorrow

Of course, as more data comes in, this could change, and tomorrow could be a day like that. Tomorrow there will be a data point for PCE inflation, which tends to be the Fed’s preferred inflation measure. Estimated PCEs will rise to 6.3% year over year versus last month’s 6.2% reading, and core PCEs are expected to rise 5.2% versus last month’s 4.9% reading.

However, it should be noted that PCE and CORE PCE have a history of reaching a higher temperature than expected. In fact, since December 2020, PCE and Core PCE have been hotter than expected 19 of the last 21 times.

PCE and PCE core

Bloomberg

Of course, this does not mean that the core PCE and PCE should be hotter than expected, but it does suggest that markets may become concerned about an increase in interest rates if they are hotter than expected. The bigger problem is that personal consumption expenditures will rise, which will be a divergence from the CPI, which is starting to fade. A higher-than-expected number could cause the Fed to worry that its preferred inflation measure is headed in the wrong direction.

PCE vs. CPI

Bloomberg

I know it’s easy to get caught up in articles talking about the Fed’s potential and the future pace of interest rate hikes, and that could be a sign that the Fed is considering stopping sometime soon. But the data does not indicate that the Fed is likely to change tack anytime soon.

It is especially difficult when the market is rising and there is a fear of getting lost. But sometimes, being patient pays off.

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