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The Engineered Recovery Loses Strength

The Bureau of Economic Analysis (BEA) released its advance estimate of fourth quarter GDP growth last week, reporting a relatively strong 2.8 percent growth rate. However, the majority of that headline number was due to inventory rebuilding and real final sales were reported at a tepid 0.8 percent.

 

 

When analyzing economic data trends following the financial crisis in 2008, it is important to remember that central banks around the world have been engaged in an historic liquidity operation since then, injecting trillions of dollars that continue to support both the current economic "recovery" and equity markets. The following graph from a recent article by James Bianco on The Big Picture web site displays the explosive growth in central bank balance sheets during the past several years.

 

 

Central banks are ruling markets to a degree this generation has not seen. Collectively they are printing money to a degree never seen in human history. So how does this process get reversed? How do central banks pull back trillions of dollars of money printing without throwing markets into a tailspin? Frankly, no one knows, least of all central banks as they continue to make new money printing records.

Until a worldwide exit strategy can be articulated and understood, risk markets will rise and fall based on the perceptions and realities of central bank balance sheets. As long as this is perceived to be a good thing, like perpetually rising home prices were perceived to be a good thing, risk markets will rise. When/If these central banks go too far, as was eventually the case with home prices, expanding balance sheets will no longer be looked upon in a positive light. Instead they will be viewed in the same light as CDOs backed by sub-prime mortgages were when home prices were falling. The heads of these central banks will no longer be put on a pedestal but looked upon as eight Alan Greenspan's that caused a financial crisis.

The tipping point between balance sheet expansion being bullish for risk assets versus bearish is impossible to know. Given the growth rate of central bank balance sheets around the world over the past few years, we might not have to wait too long to find out. Enjoy it while it is still bullish.

As we often note, we do not believe it will be possible to withdraw this unprecedented amount of liquidity without engendering significant economic and market disruptions around the world. The central banks certainly do not have a plan in place to do so. Instead, they have chosen to implement temporary measures designed to address the immediate problem without thoughtfully considering the long-term consequences of their actions.

In a recent report on underlying inflation pressure, economist John Williams of Shadow Government Statistics reviewed the impact of these unprecedented injections on economic data trends in the US. Williams believes that the methodology used by the BEA to deflate its data has introduced a positive bias that artificially inflates their real GDP figures.

A significant issue with official GDP reporting is the nature of the inflation rate used to deflate the series. The lower the inflation rate used in the GDP's implicit price deflator (NYSEARCA:IPD), the stronger will be the inflation-adjusted level and growth reported for the real GDP. Back in the 1980s, the Bureau of Economic Analysis (BEA) introduced the concept of hedonic adjustments in determining the IPD. Hedonic adjustments altered (usually reduced) inflation estimates, based on nebulous quality concepts that had no relationship to real-world common experience. The effect was to reduce the IPD inflation artificially. Other major countries initially avoided the concept in their GDP calculations, with a number of papers discussing how the U.S. hedonic methodologies gave an artificial boost to reported U.S. economic performance, productivity, etc. relative to the rest of the world. I estimate the hedonics currently reduce the annual IPD by about two percentage points.

There is no easy way to reconcile the official GDP activity with payroll employment activity, without considering the inflation issue, and the explanation is not in sudden, miraculous gains in productivity, which simply is a residual of poor-quality numbers. The payroll employment numbers are surveyed and eventually benchmarked. Despite all the issues I have with the employment series, the numbers eventually become fairly solid. In contrast, the GDP estimates are heavily guessed at and modeled, including the IPD.

Backing-out the two-percentage point IPD understatement generates the "Inflation-Corrected Real GDP" graph, which is more consistent with the payroll numbers than is the "Headline GDP." With corrected inflation, the GDP shows the 2001 recession beginning in 2000 and extending into 2003. The 2007 recession begins in 2006, hits a bottom in 2009 and the bottom-bounces thereafter. A small upside bounce is turning down again.

The following two graphs (reprinted with permission) display the headline real GDP data reported by the BEA and the inflation-corrected GDP data calculated using the alternate formulation developed by Williams.

 

 

 

 

Of course, the degree to which the BEA methodology changes have affected real GDP data could certainly be debated, but there is no question that the reported impact of inflation has been significantly reduced. This is not surprising, given that inflation expectations play such an important role in the health of our economy, and we would expect the government to continue doing everything in its power to manage those expectations accordingly. However, at some point in the near future, we will have to face the consequences of these historic liquidity operations. The central banks believe they are equipped to deal with those consequences when the time comes, although history begs to differ, as no operation of this scale has ever been reversed without being accompanied by massive economic disruptions. Perhaps this time will be different. We will see.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.