U.S. GDP revisions, inflation slippage tighten Fed’s policy bind

August 1, 2013

Richard Leong contributed to this post

John Kenneth Galbraith apparently joked that economic forecasting was invented to make astrology look respectable. You were warned here first that it would be especially so in the case of the first snapshot (advanced reading) of U.S. second quarter gross domestic product from the U.S. Bureau of Economic Analysis.

Benchmark revisions to U.S. gross domestic product made for a bit of a mayhem for forecasters, who were way off the mark in predicting just 1 percent annualized growth when in fact the rate came it at 1.7 percent. Morgan Stanley had predicted a gain of just 0.2 percent.

Hours after the GDP release, Federal Reserve officials sent a more dovish signal than markets had expected, offering no hint that a reduction in the size of its bond-buying stimulus might be imminent. In particular, they flagged the risk to the recovery from higher mortgage rates as well as the potential for low inflation to pose deflationary risks.

Little wonder: The central bank’s preferred inflation measure was just reported to have dipped to a paltry 0.8 percent, less than half the Fed’s 2 percent inflation target. The Fed said in its statement:

The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.

Fed officials know that, with interest rates already at zero and the central bank’s balance sheet at $3.5 trillion, deflation would be the tougher battle to fight.

For Eric Green at TD Securities, the GDP recalibration is dovish for interest rates, but should not prevent Fed officials from tapering bond buying at their next meeting.

The GDP revisions work counter to Fed efforts to push nominal growth, inflation, and ultimately productivity higher. […]

(But) since the revision does nothing to alter expectations for growth going forward, it does not alter our view that the tapering ship has sailed. September is priced in and the Fed will deliver.

Green’s research note, however, was published before the Fed’s latest policy announcement.

Here was the reaction of Craig Dismuke, chief economic strategist at Vining Sparks, afterwards:

This is a substantive acknowledgement of a risk to disinflation. Inflation is well below the Fed’s target and could be detrimental to the economy. This could change when and how quickly the Fed would reduce its bond purchases. It’s not a game-changer. They are trying to talk yields down.

Reuters markets editor David Gaffen puts it even more categorically.

Let’s call this one early – the September taper is off the table, despite what the myriad forecasters think and the Fed’s insistence that it’s data-dependent.

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