June 5, 2015
GDP declined 0.7% in the first quarter. This contraction worries policymakers at the Federal Reserve who are contemplating the first rate hike in six years. They worry that if such factors as bad weather and labor disputes can push the economy into a tailspin, then it must be sufficiently fragile that it cannot withstand even slightly higher interest rates. However, economists at the Federal Reserve Bank of San Francisco note that first quarter GDP growth has consistently been the weakest quarter every year since 2010. They believe that this persistent first quarter weakness is a statistical anomaly and that growth in the first quarter of this year is actually understated by about 1.5%. If that is true than the economy actually expanded at a 0.8% rate in the first quarter rather than declining 0.7%. Given unusually cold winter weather, the labor dispute by dockworkers on the West Coast, and a sharp drop in oil drilling activity caused by lower oil prices, growth of 0.8% does not seem particularly troublesome.
Virtually all economic data are adjusted for seasonal normal seasonal movements. For example, retail sales increase dramatically in the fourth quarter of every year because of the Thanksgiving and Christmas holidays but then fall almost as rapidly in the first quarter. Construction activity drops off during the winter months but rebounds once the weather improves in the spring. These wild seasonal swings make it difficult to determine the underlying pace of economic activity. By eliminating very normal repetitive seasonal movements caused by recurring weather and holiday patterns, seasonal adjustment makes it easier to observe the true rate of growth in the economy.
If these adjustments are made correctly, GDP growth for any particular quarter should not be consistently stronger or weaker than any other quarter. The San Francisco Fed economists note that in the 1980’s all four quarters were of roughly equal magnitude. In the 1990’s and 2000’s first quarter growth was 1.0% less than in the other three quarters. But from 2000-2014 the first quarter shortfall jumped to 2.3%. That is not supposed to happen. Something has changed and current seasonal factors are depressing first quarter GDP growth far more than they should.
The Fed economists re-adjusted the data and concluded that first quarter GDP growth this year should be about 1.5% higher than it currently is, or 0.8%. Because seasonal adjustment does not impact growth for the year as a whole, this means that GDP growth in the second, third, and fourth quarters will all be lower by perhaps 0.5% each quarter.
Why does this matter? Because it implies that GDP growth in the early part this year was substantially stronger than it appears at the moment. Right now we believe that first quarter GDP growth declined 0.7%. We currently expect second quarter GDP growth to be about 3.0%. That means that growth in the first half of the year was relatively anemic at 1.2%. But suppose that at the end of July when the Bureau of Economic Analysis revises its seasonal factors we learn that first quarter growth is actually 0.8% and second quarter growth comes in at 2.5%. Now GDP growth in the first half averages 1.7%. If Fed officials believe that potential GDP growth is 2.0%, this GDP revision should reassure them that the pace of economic expansion is not nearly as “fragile” as current data suggest.
GDP growth is one part of the equation that the Fed is using to determine when it is time to raise rates. GDP growth of 1.7% (after revision) for the first half of the year combined with an expectation that second half growth will pick up to about 3.0% does not make a compelling case for higher rates.
However, the labor market is quite tight with the unemployment rate close to its full employment threshold of about 5.5%, jobs are climbing 225-250 thousand per month, and labor costs and the core rate of inflation gradually are accelerating.
Given all of the above we believe that a June rate hike is still possible, however the Fed will most likely continue to pave the way for an increase later this year.
Stephen Slifer
NumberNomics
Charleston, SC
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