News that US Q2 GDP dropped by less than expected, with the 1% fall in GDP over the quarter far smaller than the annualised 6.4% drop in the previous quarter, adds to the plethora of evidence highlighting that the US recession is coming closer to ending. The bad news, albeit backward looking was revealed in the downward revisions to growth in the previous quarters, which indicated that the recession has been more severe than previously thought.
Within the Q2 GDP data the details revealed that consumer spending weakened by far more than expected. The recession is also breaking all sorts of records as the annual 3.9% decline in growth was the biggest since WWII and the fourth quarterly decline in a row was the longest on record. Nonetheless, inventories look a lot leaner following their sharp drop over the quarter and the deterioration in business investment appears to be slowing. The data also showed that the Fed´s preferred gauge of inflation (core PCE deflator) remained relatively well behaved.
The downward revisions to past data and the fact that growth was boosted in Q2 by government spending as well as very weak consumer spending will takes some of the shine off the less than forecast drop in GDP. Nonetheless, the data is still backward looking. The evidence of recovery highlighted in recent housing data as well as some bottoming out in manufacturing conditions, taken together with less severe readings in jobs data are difficult to ignore. This was echoed in the Fed´s Beige Book which revealed that economic deterioration was becoming less marked.
The most worrying aspect of the report and something that cannot be downplayed however, is consumer spending. Massive wealth loss, rising unemployment, tight credit conditions, reduced income and consumer deleveraging all point to a very subdued outlook for the US consumer in the months ahead and only a gradual pace of economic recovery. The US savings rate is set to move higher even from its current 15 year high and spending on big ticket items will remain fragile at best. Although the upcoming US jobs report will likely show a less severe pace of Job losses in July, the drop in payrolls will still remain significant and hardly conducive of a turnaround in spending.
Although some policy makers have indicated that policy should not be kept too loose for too long the weak consumer outlook suggests that inflation is likely to remain subdued for a long time to come. So whilst it is easy to get excited about the signs of recovery increasingly being revealed in economic data this should not be taken as a cue to reverse policy. The recovery process remains a “long, hard, slog” and the massive excess capacity in the global economy, especially in developed countries suggests that interest rates will remain at ultra low levels for many months.
Some clues to central bank thinking will be seen over coming days as interest rate decisions in Australia, UK, and Eurozone move into focus. Although none of the Banks are expected to tighten policy it will be interesting to see whether the rhetoric becomes more hawkish. The RBA in particular will likely indicate that the room for further rate cuts has diminished. In Europe, following the very soft inflation data in July the ECB will be comfortable in its current policy settings. In the UK attention will focus on the BoE´s asset purchase programme and the possibility of increasing purchases from the current GBP 125 billion, especially after the MPC surprisingly did not increase purchases at its last meeting.