GDP Report Could Alter Fed’s Monetary Policy

Although a single economic indicator usually carries little value, tomorrow’s announcement of Gross Domestic Product (GDP) growth could be the exception. The third quarter GDP growth is expected to be around 3.2% (annualized). If the growth is at that level, next week’s Fed meeting might produce the first indication of an interest rate rise.

First, a discussion of what GDP is and how it is reported.

GDP is the total output of goods and services produced by labor and property located in a country. This is the preferred measure used by countries to evaluate their economies. The basic measure is the real, seasonally-adjusted GDP annualized growth rate. “Real” means inflationary effects are removed. “Seasonally-adjusted” means numbers are recalculated to remove typical calendar quarter differences. “Annualized” means quarterly rates are presented as if they were in effect all year (e.g., a 1.00% quarterly growth rate would be reported as a 4.06% annual number).

Below is a table of the GDP growth rates for the past 2½ years.

Now let’s look at how the Fed is thinking. Their dual concerns have been stabilizing the financial markets and encouraging economic growth. Financial markets are looking good, so the economy is now their primary concern. By looking at the Federal Open Market Committee’s statements, we can see their take on the economy. (Selected items are shown at the end of this write-up.)

Note how the economic conditions statements have steadily improved. However, the “exceptionally low” interest rates comment has not changed. This is where the GDP report comes in. If GDP growth is as expected, the statement the Fed releases next week will likely be more positive regarding the economy. And that would increase the chance that the longstanding “extended period” phrase will be tweaked to signal that rates may be raised in the near future.

For investing, this semantic change could cause the US dollar to rise and bond prices to fall.

Federal Open Market Committee statements

(Changes are highlighted)

December 16, 2008 (date of initial drop to near zero rates):

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

…economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

January 28, 2009:

…the economy has weakened further.

…economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

March 18, 2009:

…the economy continues to contract.

…economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

April 29, 2009:

…economy has continued to contract, though the pace of contraction appears to be somewhat slower.

…economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

August 12, 2009:

…economic activity is leveling out.

…economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

September 23, 2009:

…economic activity has picked up following its severe downturn.

…economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

November 5, 2009:

???

This entry was posted on Wednesday, October 28th, 2009 at 2:47 pm and is filed under Investment Insights. You can follow any responses to this entry through the RSS 2.0 feed.