Growth in Q3 a Bit Stronger Than Initially Estimated

The Bureau of Economic Analysis (BEA) reported that economy, as measured by growth in real gross domestic product (GDP) rose by 3.3 percent in the third quarter of 2017. The second estimate of Q3 GDP growth is moderately higher than the initial, or “advance”, estimate. With this reading, GDP growth has accelerated for two consecutive quarters after decelerating over the second half of 2016.

The second estimate of GDP growth in the third quarter of 2017 confirms that personal consumption expenditures (PCE) was the largest contributor to the overall growth rate of GDP. This largely reflects the fact that PCE accounts for approximately 70 percent of GDP. The higher estimate of GDP growth with the second estimate reflected larger contributions by private investment, government spending, and imports. The total value of imports are subtracted from GDP, so the greater positive contribution of imports to GDP reflected a larger percentage decrease in imports over the quarter.

A previous post illustrated how the current level of GDP is now above the potential level of the economy as measured by the Congressional Budget Office. The federal funds rate is typically raised under these conditions. The figure below extends that analysis by demonstrating how closely the rate on the 3-month Treasury bill tracks the federal funds rate. Increases in the federal funds rate typically coincide with a higher 3-month Treasury bill rate and vice versa.

Previous analysis hypothesized that the federal funds rate could likely rise by an additional 125 to 150 basis points under current economic conditions over the next few years. This would be equal to five or six 25 basis point rate hikes. Since the rate on the 3-month Treasury bill tracks the federal funds rate, then this rate is expected to increase approximately 125 to 150 basis points as well.

Assuming that the inflation compensation portion of the 10-Year Treasury note rate returns to 2.0 percent (it was estimated at 1.86 percent as of October 2017), than the 10-Year Treasury note rate could increase an additional 74 basis points over the next few years from the 2.36 percent rate recorded in October 2017. In this scenario, the rate on the 10-Year Treasury note would rise more slowly than the 3-month Treasury bill rate and the difference between the two would shrink, indicating that the yield curve should become flatter in the coming years.

An earlier post illustrated how a flattening yield curve reflects the comparative strength of the economy in the short-run relative to the longer-run, but it also reflects actions taken by the Fed. On the one hand, previous analysis suggests that the slower increase in the 10-Year Treasury note rate also reflects the slow pace of normalization of the Fed’s balance sheet. This would suggest that yield curve is flatter than it should be, but at the same time, while the increase in the 3-month Treasury bill rate also reflects increases or expectations of future increases in the federal funds rate, which are believed to be tied to an improving economy, the federal funds rate itself is considered “accommodative” by the Fed, indicating that it is lower than it should be given the economic recovery.

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