A Low-Quality GDP Report

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The U.S. economy grew at a 3.5% rate in the third quarter, above expectations. I'm here today with Bob Johnson--he is our director of economic analysis--to look at the quality of this growth.

Bob, thanks for joining me.

Bob Johnson: It's great to be here today.

Glaser: This number was ahead of consensus estimates. Where do you put it? Was it about what you expected?

Johnson: It was a little bit higher than what we had all been looking for, but it was within the realm of what was possible. It was a good headline number. It was certainly a number I'd take. It certainly wasn't a bad number at all. But I will say it was a relatively lower-quality number.

Glaser: Now, how much of this increase and last quarter's as well, which also was very strong, is just more of a rebound from the cold weather we saw earlier in the year?

Johnson: I think that that certainly has had an effect. I think things clearly were very slow. Remember, everybody is all excited about having two back-to-back quarters of over 3% growth or whatever and the best growth over a six-month period in back quite a ways. That's really not the right way to look at it because the weather did indeed pull the numbers down pretty dramatically in the first quarter. And what we really just saw was kind of a bounce back from that.

Glaser: So, you mentioned that this wasn't the highest-quality number. What were some of the factors that were driving the outperformance?

Johnson: There are probably a couple of things I could talk about. But let me focus on two in particular. One was the government number. Government contributed, both local and state, over 0.8% to the GDP calculation, and nobody had expected that the government would make that big a contribution. And when you break it down, it was primarily because of a large increase in defense spending that kind of poked the number back up.

So, that's why the GDP number looked so good. Nobody was anticipating it. So, people were really surprised by how good the number was. But the primary reason was the government number.

There was one other number in the report: Exports were particularly strong. We thought they would be a little strong, but they turned up a little bit stronger--probably because of the estimates that the government made in the final month of the quarter, which aren't in yet. We'll know in a week or two what the actual numbers were, but they had to put an estimate in there now and it looked like the export growth was pretty robust. That doesn't quite fit with a slowing world economy so much. Now, maybe there were some oil-related things that were in there and some one-time things. But even if the number is correct, which it may end up being correct, we certainly don't anticipate that it will be that big of an adder going forward, because with the dollar stronger and the economies overseas weak and the farm products not doing all that well right now, you roll all that together and it just makes it hard to see how exports will be that big of a contributor, say, in the fourth quarter or even next year.

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Glaser: What did the consumer do in the quarter then?

Johnson: That's one of the reasons I say it's one of the lower-quality quarters. I'm so focused on the consumer. It's almost 70% of the GDP calculation, and I always talk about the virtuous--or could be the vicious--cycle of the consumer. If the consumers spend more, then the businesses have to ramp up, and that means they hire more--maybe if it's strong enough, they'd even buy more capital goods. When they do that, that means hiring more workers or paying their current workers more and that means more income and that means more spending and more spending means more business buildup.

So, that's the virtuous cycle and, certainly, this was not a great quarter for consumption at 1.8%. The trend has been more like 2.25%. So, we were kind of below trend on the consumption number. That was not a good thing to see. It was pretty much as expected because of the retail sales reports, but it was a weak number. And I'm hoping because of the high savings rate that we can improve that in the fourth quarter, but it's certainly one of the reasons why I say this was a low-quality GDP report.

Glaser: You have this kind of middling consumption data and then you also have the likelihood that the federal government probably won't be able to sustain that military spending, and the export data could be problematic with the strong dollar. What does that mean for your outlook for the fourth quarter and for the full year?

Johnson: I think we'll still have a decent fourth quarter. I think we'll probably in the 3% range. So, we'll kind of be trending down from the over 4% to 3.5% to 3%. And by the way, for the full year, that pulls us into my range of 2% to 2.5%. We'll be at 2.3% if we get my number, the 3% number in the fourth quarter. So, that's kind of my expectation.

And then as I look forward to the following year, we're back to that 2% to 2.5%--we've kind of washed the weather stuff through, we've got the big export push out of the number, and we've got the government-spending number not being the big blip that it was. So, again, it's a slow number, but it's not an awful number at 2% to 2.5%. I think the idea that the 3% number means we're off to some big, high new growth rate is not true. The demographics just aren't there.

Glaser: If we're in this slow-growth world, how does this impact the Federal Reserve? They had a statement this week ending the QE program, potentially raising rates next year. How does the Fed look at a report like this?

Johnson: Again, they are a lot more focused on the labor data than the GDP data. That's kind of their dual mandate to keep employment high and to keep inflation low. That's their official charter. So, this report is a little less important to what they do, but they look at all the data. But certainly, this data is relatively strong and would be supportive of ending the QE programs, ending anything extraordinary and maybe, yes, thinking about raising rates.

So certainly, there is nothing in the reports to change any of that. I think yesterday, in the Fed's release, they talked about how labor markets were beginning to tighten up a little bit. There wasn't as much slack, as it were, and it kind of took a bow, if you will, for QE. It has helped the labor markets as we've gone from over 8% unemployment to 5.9% unemployment; we've begun to add more jobs per month than we had been. The program is effective; it's done its job. And the Fed said they're going to still keep rates low, but certainly there was some language around that statement that kind of said, "Well, we're seeing things picking up a little bit, so watch out."

And again, I want to stress: I don't care, and long-term investors shouldn't care, if they raise the rates in March or June or September. A day trader absolutely should because the day they raise rates, the markets will probably go down 5% to 10%, just as shock value. But then things will settle back and people will realize with the kind of growth rates we have with corporations needing less cash, with baby boomers saving cash and wanting fixed income, all of those things will keep a long-term lid on interest rates. And yes, we'll have a short-term pop, but I don't think we're going to have any big increase, and I'm not terribly worried about when the Fed decides to do something.

Glaser: Looking at that dual mandate, though, what about the inflation side of it? The Fed doesn't seem that worried about it. Is there anything that you're concerned about right now?

Johnson: I'm certainly not concerned. Certainly, in the GDP report today, we saw the inflation rates very low, way under 2%--both when you include food and energy or when you don't. They were both pretty stellar numbers in terms of being low. Not as low as the EU that gets you scared that we're going to have deflation, but still kind of below the 2% level that they usually like to think in terms of. Looking ahead, I think the Fed is not going to have to worry too much about inflation. I think they've dramatically increased their balance sheet, and a lot of people are worried about what that's going to do long term. Well, now they've stopped building that balance sheet. And I think that balance sheet hasn't become inflationary because of different rules out there to force banks keep more capital, be more careful with how they lend the money, and frankly, pretty strict mortgage requirements.

So, a lot of that excess cash when they bought those bonds is kind of sitting in bank reserve accounts and hasn't had a dramatic impact on the economy either growth-wise or inflation-wise, and I don't see any reason for that to change.

Glaser: Bob, I appreciate your take on this report today.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.