On GDP, Fed Forecasts and Tapering Tapering

What will new Fed head Janet Yellen make of the latest GDP data? Photo by Mark Wilson/Getty Images.

“It was the best of times, it was the worst of times.” Charles Dickens’ famous opening line sure seemed to apply Friday, when headlines greeted a sizable downward revision to Q4 US GDP growth in typically bipolar fashion. “US fourth-quarter growth cut, but outlook improving.” Or is it: “US GDP report raises new questions about recovery’s strength.” “GDP is down but economy will be just fine.” But wait, “Economy just muddling along.” Yes, it’s safe to say sentiment remains stuck between skepticism and optimism—a bullish sign, as we explain here and here. In our view, the optimists have it right: News of slower growth isn’t wonderful, but there were some encouraging signs in the underlying data. And, more importantly, more recent and forward-looking indicators suggest growth should continue from here—more fuel for the bull.

Overall, the numbers were mixed. Growth was revised down from the advance estimate of 3.2% annualized to 2.4%. Consumer spending got knocked from 3.3% to 2.6%, and exports eased from 11.4% to 9.4%. The government was a drag, with a drop in state and local spending pulling the total from -4.9% to -5.6%—not a sign of underlying economic weakness, but demand is demand. But other components—and key measures of private sector health—were revised up! Imports—a gauge of domestic demand—rose from 0.9% in the advance estimate to 1.5%. Yes, higher import growth detracts more from total growth, but it’s good—statistics are just weird sometimes. Business investment was also revised up, from 3.8% to 7.3%, and its subcomponents were striking. Investment in equipment—think computers and factory machinery—rose from 6.9% to 10.6%, and investment in intellectual property (e.g., software, patents and R&D) jumped from 3.2% to a whopping 8%. It seems earlier jitters businesses aren’t “investing in the future,” were a tad premature—corporate America is alive and well and has a firm eye on the future. If you own stocks, this is what you own a share in.

Other than that, we’d suggest not trying to glean many forward-looking implications from the report—it’s the second estimate of economic data now two to five months old. The past doesn’t write the future. But some don’t see it this way. Instead, they’ve seized on this report as the latest in a string of not-so-great news, which might cause the Fed to stop or slow its “tapering” of quantitative easing bond buying—taper the taper, if you will. New Fed head Janet Yellen started the frenzy Thursday, when she told the Senate it isn’t clear whether the “softer spending” apparent in recent retail sales, consumer spending, home sales and industrial production was solely a product of dismal weather, or if creeping economic weakness played a role. If it’s the latter, she said, “we would be open to reconsidering” reducing asset purchases (though this came with a fair amount of hedging).

How the Fed plays this is anyone’s guess, as usual. Rational minds would assume policymakers would look at forward-looking indicators, like the Leading Economic Index (high and rising), new orders (still growing), order backlogs (piling up), the yield curve spread (widening) and loan growth (accelerating, with long-suffering categories like mortgages, property development and consumer credit finally turning up). However, the Fed, like most organizational forecasters, tends to base its outlook on past data, regularly revising its forecast as new results come in. Could the Yellen Fed break with that practice? Maybe! But newly released transcripts of all the Fed’s 2008 meetings and conference calls show she’s prone to looking backward, too. A sample follows.

1/30/2008: Like the Greenbook, I downgraded my economic outlook substantially since our last in-person meeting. The December employment report was probably the single most shocking piece of real side news prompting this revision.

6/25/2008: Real-side data came in considerably stronger than I anticipated, so like the Greenbook I have adjusted up my forecast for growth in the current quarter.

8/5/2008: The moderate growth rate registered in the second quarter was disappointing, especially because it benefited from the temporary effects of the fiscal stimulus package. Moreover, the pattern of consumer spending during the quarter, with weakness in June, is worrisome. With all the publicity surrounding the rebate checks, households may have put them to work earlier than usual, especially since they were facing significantly higher prices for food and gasoline. This interpretation does not bode well for activity in the current quarter. Assuming no change in the funds rate this year, we have lowered our forecast for real GDP growth for the second half of the year about 1/3 percentage point, to just 3/4 percent, and project a correspondingly higher unemployment rate.

10/28/2008: In the run-up to Halloween, we have had a witch’s brew of news. Sorry. [Laughter] The downward trajectory of economic data has been hair-raising—with employment, consumer sentiment, spending and orders for capital goods, and homebuilding all contracting—and conditions in financial and credit markets have taken a ghastly turn for the worse. It is becoming abundantly clear that we are in the midst of a serious global meltdown. Like the Board staff, I have slashed my forecast for economic activity and now foresee a recession with four straight quarters of negative growth starting last quarter.

Granted, this happened more than five years ago—perhaps she changed her feathers in the interim. This also isn’t a roast of her forecasting abilities. We aren’t aware of anyone who got 2008 right—at least not for the right reasons. But it does illustrate the approach she has historically taken, and investors would do well to bear this in mind as Fed forecasts come out. They aren’t foolproof or ironclad.

Neither is Fed guidance. Policymakers may deliberate ad infinitum over the semantics (the 9/16/2008 transcript included six pages of debate over a single adverb), but the plans outlined in each Fed statement aren’t set in stone. They’re words—words change. Minds change. Even if conditions don’t change! You can never know how human beings will react to a certain piece of news, never mind the dozens of data points policymakers digest at each meeting.

But whether we have a taper, a tapered taper or no taper, it’s clear the US economy has plenty of oomph, and plenty of investors still don’t quite realize it. With reality a-ok and expectations still on the low side, stocks should have plenty of room to climb.