Palm Beach, FL 12/13/11 (StreetBeat) --So the Fed’s Open Market Committee meets this week. Yeah, I know, how excited can we get about a gathering that does not include the star power of Merkozy traipsing down the red carpet, but sorry, Bernanke, Yellen, et al is the best we can do this week. Don’t worry, there is sure to be another previously unplanned EU summit sooner rather than later, but until then the FOMC will have to do.Besides, it’s not as though the Fed won’t discuss Europe and its implications for the US economy. As a matter of fact they may have a little bookkeeping to do based on what they did on behalf of the continent in the last couple of weeks. When the Fed reduced its charge for dollar liquidity from 100 basis points down to 50 basis points for various central banks including the ECB, they made it possible for European banks to borrow dollars last week at 0.59%. Although the Fed funds rate is closerthanthis to zero, the Fed’s Discount Rate, formally called the Primary Credit Rate, which is an emergency facility open to a broader range of US depository institutions than are the Fed funds, has long maintained a charge of seventy-five basis points. Although demand at the Discount Window has been in steady decline since the post-Lehman peak, these funds, which are borrowed from the regional Fed banks, remain in consistent demand in the New York District and for smaller amounts across a smattering of other Fed Districts; so a reduction in the rate not merely a symbolic nod to fair play. However, the Dallas and St. Louis Fed bosses, Fisher and Bullard respectively, do not necessarily think the Fed has be quid pro quo on the Discount Rate and in recent months the Kansas City Fed board has been clamoring for a twenty-five basis point increase in the emergency rate. So a Fed move on the Discount Rate does not appear to be a unanimous conclusion.
But if the Fed wants to send a signal that further easing may be on the way, then lowering the Discount Rate is one way to do that. The economy is, at the very least, conflicted. On the one hand the Black Friday sales results were a record. On the other hand the country’s biggest retailer continues to give a very downbeat assessment of its core customers. In a teleconference presentation last week WalMart (NYSE:WMT) executives noted that “we still see our core customer under significant pressure and we still see a very dynamic and I’ll call it dramatic, paycheck cycle.” At the time of month when the “folks get their benefits electronically, coming in the night before and really walking through the registers right after they activate their benefits. And this continues in our business cycle.” They also see their customers “trading down from a national brand to one of our private brands or from a number one brand to a number two or three brand within a category. We’re also seeing them change pack sizes, so they’ll buy a half-gallon milk rather than full-gallon milk.”
Fair enough, even though the consumer is seventy percent of the economy this example may be too narrow a slice to be representative of the whole pie.
So let’s look at the growth rate of the entire economy to see if the Fed will be anxious to tip their hand. But once again there is conflict. The latest reading of the GDP, for the third quarter, is +2.0%, quarter on quarter annualized. While this is nothing to write home about it is not something that in and of itself is going to set the Fed’s hair ablaze. But there are two broad measures of the economy and the other one, Gross Domestic Income (GDI) was +0.4% on a quarter on quarter annualized basis in the third quarter and was up just 0.2% in the second quarter; results that warn of trouble up ahead.
In the September 1, 2008 TWA I wrote about the differences in these two measures of the economy, quoting from a Fed paper from 2004 called Integrating Expenditure and Income Data: What to do with the Statistical Discrepancy?; “the better known measure, gross domestic product (GDP), is the sum of private and government consumption and investment (including inventory investment) and net exports. A second measure, gross domestic income (GDI), is the sum of factor and nonfactor payments paid to input providers; these payments include compensation, profits and profit-like income, production and import taxes (formerly known as indirect business taxes), and the consumption of fixed capital. GDP and GDI conceptually measure the same thing, but because the two are calculated using imperfect source data, the two measures differ by what is called the statistical discrepancy.” In simpler terms GDP is a consumption based measure while GDI is income based, highlighting things like personal income and corporate profits.
But the dirty little secret of these economic data points is that for the last couple of decades, “the GDI, despite its relative obscurity, has been the more accurate measure of output growth more often than not,” said Fed economist Jeremy Nalewaik, who has done extensive research on the pair, in an interview with FT Alphaville earlier this year. Not only that, but “since the mid-1990s, GDP has tended to revise toward GDI, and not the other way around,” Nalewaik says. Maybe it’s the economic shift towards the service sector and away from manufacturing that is the cause of the GDI superiority, but that it is more accurate is not in question.
But even more important for this discussion of the Fed is that the GDI is the more prescient of the two measures of growth in regards to signaling the possibility and onset of recession. In Nalewaik’s 2006 paper Estimating Probabilities of Recession in Real Time Using GDP and GDI he concludes, “the main finding is that, no matter what benchmark one uses, real time GDI has done a substantially better job recognizing the start of the last several recessions than has real time GDP.” But in addition Nalewaik has looked at the predictive power of both measures of growth to see if they indicate a recession will follow when the economy has fallen into an “economic stall speed”. In a nutshell he defines stall speed as a level of quarterly growth below one percent, from which “the economy has tended to move into a recession within a fairly short time span.” In his 2011 paper Forecasting Recessions Using Stall Speeds he says there is “a considerable amount of evidence and logic showing that GDI provides a better measure of output growth than GDP, its better-known counterpart, and in our work here, while stall phases are evident in GDP, they are more plainly visible in GDI.” In this paper he shows that for GDI “sixty four percent (14 out of 22) of expansion observations of below one percent growth were in the four quarters prior to recessions. For GDP, a little less than half (12 out of 25) of expansion observations of below one percent growth were in the four quarters prior to recessions.” While the probability that a stall speed GDI will lead to a recession is of interest so too is the likelihood that a recession was preceded by a stall speed reading of this measure of growth. As Nalewaik says in this paper, “eighty two percent of postwar recessions (or 9 out of 11) were preceded by a GDI growth rate of one percent or less in al least one of the four quarters prior to the recession, with the 1953-54 and 1973-75 recessions being the only exceptions.”
My phone message to Nalewaik on the current situation, and whether or not the two consecutive readings of stall speed GDI, +0.2% in Q2 and +0.4% in Q3, will increase the probability of a recession in coming quarters, has not yet been responded to. But I would hazard a guess that it doesn’t hurt as an indicator.
The 2008 TWA on this topic was called A Man with Two Watches, because of the French proverb that says, “A man with one watch knows what time it is; a man with two watches is never quite sure.” But with the current readings of the GDI and with the trouble in Europe threatening to be an unwelcome export, it might be later than we think. The Fed may not be ready to move this week, but they may indicate that they hear the clock ticking and won’t wait for long before they do, especially if they focus on the GDI.
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