An almost audible sigh of relief is conveyed in the statement that followed the July meeting of the Federal Open Market Committee (FOMC) as the committee upgraded its assessment of the economy and the Bureau of Economic Analysis (BEA) released estimates of economic activity for the April to June quarter, including 4.0% growth in GDP.
The BEA reported that real GDP grew at a seasonally adjusted annual rate of 4.0% in the second quarter, bouncing back from an upwardly revised 2.1% contraction in the first quarter. Some rebound in growth was widely expected based on early monthly data releases but the jump to 4.0% beat most expectations. Growth was broad based with most sectors of the economy recovering from outright declines or weakness in the first quarter.
Two sectors that warrant caution with regard to sustaining this strength going forward are inventory investment and imports. A slowdown in the pace of inventory accumulation was a significant contributor to the decline in growth in the first quarter. That pace has accelerated but may have gone too far, which could lead to another pullback and a drag on third quarter growth.
Falling exports were also a significant contributor to first quarter weakness but weakness in imports (which subtract from GDP growth) prevented the net effect of trade from being worse. Exports have recovered, contributing more than a percentage point to growth in the second quarter, but a stronger recovery in imports generated a net effect of subtracting 0.6 percentage points from GDP growth. The effects of another round of inventory adjustment and continuing strength in imports are reasons to suspect that third quarter GDP growth will fall back below 4.0%
Today’s report also included revisions to earlier years with the largest effects being concentrated in the most recent three years. Real GDP growth was modestly higher in 2013 than was previously estimated, 2.2% rather than 1.9%, lower in 2012, 2.3% rather than 2.8%, and lower in 2011, 1.6% rather than 1.8%. Growth in 2010 was unchanged at 2.5%.
The FOMC must have been encouraged by the stronger than expected economic growth, confirming that the first quarter weakness was from transitory factors, but also by the information on prices included in the BEA release.
The FOMC has been in the unusual position of worrying about inflation being below the committee’s target rate of 2.0% and the language in today’s statement following the meeting reflects that concern. In recent meetings the language in the statement has expanded beyond the usual references to the dual mandate of maximum employment and price stability to include explicit references to the harm to economic growth posed by inflation running persistently below the 2.0% target.
Today’s statement included the committee’s recognition that inflation has moved closer to the target, their judgment that the risk of persistently below target inflation has diminished, and their willingness to keep the federal funds rate at its current low level if inflation remains below the target.
Inflation as measured by the GDP deflator, the broadest measure of prices across the economy, rose to an annual rate of 2.0% after hovering below that rate since late 2012 and averaging 1.4%. The FOMC’s preferred measure, inflation at the consumer level as measured by the price index for personal consumption expenditures rose to an annual rate of 2.3% from 1.4% in the first quarter. Excluding the volatile categories of food and energy, core inflation at the consumer level was 2.0%, up from 1.2% in the first quarter, and an average of 1.3% since late 2012.
With strong economic growth and an improving inflation environment the committee upgraded its assessment of the economy but also repeated that while improving the labor market and housing sector remain weak. Monetary policy will remain accommodative with the expectation that economic conditions will continue to improve. The Fed will continue winding down the asset purchasing program and keep the federal funds rate low as long as the economy continues to improve in line with the committee’s projections. The bond buying is on track to end after the October FOMC meeting and the federal funds rate will remain at its current level for “a considerable time” after that.
The FOMC meeting produced no major surprises and the 4.0% GDP growth was a pleasant surprise. This is a pair of outcomes that should provide at least some momentary relief.