FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
July 28, 2015

IN THIS ISSUE:

1. Chair Yellen All But Promises Rate Hike This Year

2. Why is the Fed So Preoccupied With Raising Rates?

3. Thursday’s 2Q GDP Report Could Be a Surprise

4. Annual GDP Revisions Could Give Fed Green Light

Overview

The next few days should be an interesting time in the markets. The Fed Open Market Committee (FOMC) is meeting today and tomorrow and will release its latest policy statement at the conclusion of the meeting. While it is not expected that the Committee will vote to raise the Fed Funds rate at tomorrow’s meeting, Fed Chair Janet Yellen has been talking hawkishly about a rate hike of late.

Friends, business associates and clients increasingly ask me: Why is the Fed so intent on raising interest rates? The US economy is not that great, the global economy is slowing down, inflation is practically nonexistent and commodity prices are signaling deflation. So why on earth is the Fed hell-bent on raising rates when much of the world is doing just the opposite? I’ll tell you why as we go along today.

Then on Thursday, we get the first estimate of 2Q GDP from the Commerce Department, and there is an unusually wide range of pre-report estimates. While there is broad agreement that the economy bounced back after the disappointing 1Q rate of -0.2%, some forecasters believe the 2Q estimate will be less than 1%, while others believe it will be north of 3%. That’s a huge spread! The Atlanta Fed’s rolling “GDPNow” indicates 2Q growth of 2.4%.

Yet perhaps the most important news of this week will be the Commerce Department’s annual revisions to its GDP numbers going back several years on Thursday. While such revisions happen every year, this year’s revisions and changes are expected to be more significant than usual as the government tries to smooth-out “seasonal adjustments.” Many expect that the 1Q GDP estimate of -0.2% could be revised to a slightly positive number. This will be big news.

Chair Yellen All But Promises Rate Hike This Year

Janet Yellen has been in the spotlight a lot this month. She gave a policy speech at The City Club of Cleveland on July 10, and then testified before the House of Representatives and the Senate on July 15 and 16. As noted above, the FOMC is meeting today and tomorrow, although this meeting does not include a Yellen press conference afterward.

The FOMC meets eight times a year, typically about every six weeks. Of the eight meetings, four are followed by a press conference with the Chairman, or the “Chair” as Yellen requested to be addressed when she took the helm last year.

Of course, the question on everyone’s mind is when will the Fed announce the first Fed Funds rate hike since 2006? In Cleveland, Ms. Yellen said:

“I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term…

I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step…

We are close to where we want to be, and we now think that the economy cannot only tolerate but needs higher interest rates.”

Most Fed-watchers still believe the most likely time for the first rate hike, or liftoff as it’s called, will be at the September 16-17 FOMC meeting, which is the next time for a scheduled post-meeting press conference with Ms. Yellen.  The assumption has been that the Fed would not raise rates at an FOMC policy meeting that did not include a Yellen press conference afterward to explain the reasoning.

However, Yellen cast some doubt on that assumption in her recent congressional testimony. In answer to a question, she reportedly replied that the first rate hike could come at virtually any upcoming FOMC meeting – regardless of whether a post-meeting press conference was scheduled or not – if the economy continues to improve.

In fact, this issue was actually discussed by the Committee at the March 17-18 meeting when it noted that if the first rate hike occurs in a non-press conference meeting, Ms. Yellen could call a special press conference to discuss the decision.

Why is the Fed So Preoccupied With Raising Rates?

The question I am increasingly asked is, Why is the Fed so hell-bent on raising interest rates? The US economy is not that great, the global economy isn’t either, inflation is practically nonexistent and commodity prices are signaling deflation. So why on earth is the Fed so intent on raising rates when much of the world is doing just the opposite?

There are several reasons. First, the Fed’s economic assumptions have been too optimistic for the last several years and, as such, it has been preoccupied with inflation coming back – which hasn’t happened.

The Fed’s favorite measure of price inflation is the Personal Consumption Expenditures Index (PCE) which is published monthly by the Commerce Department’s Bureau of Economic Analysis.  For the 12 months ended May, the PCE rose only 0.22%, which is a long way from the Fed’s target of 2%. Excluding food and energy, the PCE is only up 1.24% year over year. As you can see, the trend is still going in the wrong direction, at least from the Fed’s standpoint.

Second, the Fed has a long history of being late to take action, going all the way back to the Great Depression.  Yellen, like her predecessor Ben Bernanke, believes that a near-zero Fed Funds rate is simply not normal and is anxious to “normalize” it. In the quote above, Yellen says the economy “needs higher interest rates,” but she did not say why.

There are plenty of theories as to why the Fed is so preoccupied with raising rates. But I believe it all boils down to this: The Fed is intent on raising rates in order to reload for the next recession. The Fed feels desperate to lift the Fed Funds rate several notches higher as soon as possible in order to be able to lower it again when the next recession comes along.

The problem is the current economic recovery is so feeble that Fed rate hikes could actually be the spark of a new recession. This explains in large part why the Fed has held off as long as it has. But as Yellen has expressed in recent weeks, she and most of her colleagues feel that the time has come to get started. My guess remains that we’ll see a modest rate hike in September.

Then the question is, how much? Here, too, theories abound. While it fluctuates daily, the Fed Funds rate has averaged around 0.13% in July. Most Fed watchers agree that the first rate hike will be only 25 basis points, thus raising the rate to around 0.38%. Others believe it could be raised to a range of 0.25-0.40%. Still others suggest it could be raised to a flat 0.25%. The point is, it won’t be raised by much.

The next question is, how will the markets react? If liftoff is just a baby step, as suggested above, and since just about everyone on the planet knows it’s coming, you would think there would not be a big reaction in the markets. Yet the stock markets sold off hard last week for no apparent reason; however, the downturn started the day after Janet Yellen finished her congressional testimony on monetary policy and the need to raise interest rates. Coincidence?

Finally, as it pertains to the Fed and liftoff, Thursday’s multi-year GDP revisions may prove pivotal to the members of the FOMC, especially if those revisions show that the economy has been stronger than previously believed. I’ll have more on this below.

Thursday’s 2Q GDP Report Could Be a Surprise

The Commerce Department will release its first estimate of 2Q GDP on Thursday morning at 8:30 Eastern. While there is little doubt that the economy beat the disappointing -0.2% in the 1Q, there is a great deal of uncertainty about how much GDP improved in the 2Q. There is a very wide range of pre-report estimates. I’ve seen estimates as low as 0.8% to as high as 3.5%.

The consensus of forecasters surveyed by Yahoo is around 2.6%. Blue Chip Economic Indicators puts it slightly higher around 2.8% based on an average of the top 10 estimates and the bottom 10. Meanwhile, the Atlanta Fed which started calculating its own “GDPNow” numbers earlier this year has 2Q GDP at 2.4% as shown in the chart below.

As we await Thursday’s first GDP report for the 2Q, let’s keep a few things in mind. First, it is the “advance” report which will be revised two more times in August and September. Second, and more important, if the report is stronger than expected, stocks could react negatively – because traders will likely view that as a green light for the Fed to raise interest rates.

On the other hand, if the report is weaker than expected, stocks could react positively – since that might be a sign the Fed will postpone liftoff.  Based on weak retail sales in June and the stronger US dollar this year, I would expect 2Q GDP to come in below the consensus on Thursday.

Annual GDP Revisions Could Give Fed Green Light

Each summer, the Bureau of Economic Analysis updates its Gross Domestic Product estimates to incorporate sources of data previously unavailable and make improvements in methodology – all with the stated goal of providing the most accurate measure of the US economy’s performance. The latest revisions will be released this Thursday along with the advance estimate of 2Q GDP.

Many believe that this year’s revisions may be more significant than usual since the BEA has indicated it will make some changes in how it calculates its “seasonal adjustments.” Given that we have had two consecutive 1Q declines this year and last, the BEA is under pressure to smooth-out the seasonality. For that reason, some analysts expect that 1Q 2014 and 1Q this year may be revised into positive territory. That remains to be seen, of course.

The BEA will make revisions to 2012, 2013, 2014 and 1Q 2015. The BEA will use a slightly different calculation of GDP and Gross Domestic Income that some believe will lift GDP across the board. Analysts at Merrill Lynch expect that GDP will be revised up “modestly” for the years noted above. Analysts at Nomura Securities have a similar view of the upcoming revisions. If correct, it will not be the first time this has happened.

This year seems different, however. There has been a lot of pre-report “buzz” about the GDP revisions, with most analysts expecting a significant improvement. I don’t remember such anticipation in past years, much less such conviction about what the numbers will show. It makes me wonder if the Commerce Department is under pressure to make the economic numbers look better ahead of next year’s elections. It’s hard to know but it would not surprise me.

While we won’t know what the revisions are until Thursday morning, if the adjustments give GDP a further boost, that will very likely give the Fed the green light to announce liftoff at the September 16-17 FOMC meeting. This is another reason why the stock markets could react negatively if the 2Q GDP estimate and the revisions are stronger than expected.

Finally, I will analyze Thursday’s GDP report and revisions in my Blog on Thursday afternoon. If you have not subscribed to the Blog, CLICK HERE. If you subscribe now, my analysis of Thursday’s big GDP report and annual revisions will hit your inbox that afternoon. The Blog is free and we never share your e-mail address with anyone. So join the conversation!

Hoping you’re having a great summer,

Gary D. Halbert

 

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