• Real GDP growth for the recently completed first quarter of 2013 appears likely to exceed earlier expectations when the first estimate is released on April 26. Despite the drag from fiscal tightening, real GDP growth is set to register in the range of 2.5 to 3.0 percent, boosted in part by the a ereffects of Hurricane Sandy. Hurricane Sandy depressed inventory accumulation in the fourth quarter of 2012, which in turn set the stage for increased inventory accumulation in the first quarter, which could also extend into the current second quarter. The storm’s direct hit on major population and manufacturing areas on the East Coast gave it disproportionate influence on headline GDP. With inventories restocked in Q2, we could see weaker output numbers in the second half of this year as manufacturing dials back in the face of only-moderate final demand growth.
• Overlying the whipsaw from Hurricane Sandy is the wet blanket of ongoing fiscal tightening. It is important to remember that we are still in the early days of fiscal tightening. Full effects may not be felt until mid-summer. We will not know the full drag from fiscal tightening until the third quarter GDP data is released late this year. The combination of the inventory whipsaw and fiscal tightening points to slower growth in the second half of this year. We may yet be in store for a repeat of the all-too-familiar summer so patch.

• Balancing out the downside risk is upside potential from real estate, autos and labor. House prices continue to firm up throughout the country. House price gains combined with very low interest rates mean that homeowners are now building equity in their houses as rapidly as builders are building them. Commercial real estate markets are also improving nationwide. The positive wealth effect from improving house prices means that households are feeling more comfortable in taking on auto loans. Home construction and auto sales in turn support employment which drives income in a virtuous economic cycle.

• Sounds good until the jobs fail to show up, which they did in droves in March when only 88,000 payroll jobs were added on net. On a moving average basis, job growth over the past two years has centered around 180,000 jobs per month. April should show a correction back up to the 180K trend. The failure to see an upward correction soon would rewrite the narrative and increase the odds of another summer so patch. The unemployment rate dipped in March to 7.6 percent for all the wrong reasons as the labor force contracted by a size-able 496,000. Labor force growth has been surprisingly weak in the aftermath of the Great Recession.

What the Fed Said

The minutes of the Federal Open Market Committee meeting of March 19-20 show a variety of opinions within
the Fed about the desirability and possible path of ongoing quantitative easing. In the official policy announcement at the end of the March meeting the FOMC said that they will continue QE3 until the outlook for the labor market has improved substantially in a context of price stability. The weak jobs report for March (which came more than two weeks after the meeting) implies that QE3 is not going away soon.

The minutes of the meeting show a broad ranging discussion with a variety of opinions about the costs and
benefits of the current program of quantitative easing. The costs of extending QE3 include the distortion of financial markets due to exceptionally low interest rates, “cliff” effects due to the eventual wind down and end of QE3, the potential impact on financial markets of asset sales from the Fed’s expanded balance sheet, fluctuations in Fed remittances to the Treasury, potential complications in future monetary policy relative to setting the fed funds rate, unhinging inflation expectations, and devaluing the dollar (which also works as a positive for exporters).

The benefits to ongoing QE are being framed by the Fed in terms of labor markets. In undertaking another
round of QE, the Fed is trying to keep interest rates low. Low interest rates help homeowners buy new homes or refinance their old houses, thus creating jobs directly through improving real estate markets and indirectly though improved overall consumer spending. Low interest rates also incentivize businesses to expand and create jobs. QE also tends to provide a tailwind for equity markets.

Chairman Bernanke clearly desires to see a meaningful reduction in the unemployment rate. The March step-down
in the unemployment rate to 7.6 percent was not driven by job creation and so it cannot be taken a signal that
QE will end sooner rather than later.

When guessing about the possible path of QE3 it is important to remember that the FOMC is not a true democracy. The Chairman has disproportionate influence in determining monetary policy. So far Chairman Bernanke has not publicly expressed a willingness to end QE3 soon. Given downside economic risks for the second half of this year Chairman Bernanke may be looking beyond current conditions with the intent of keeping QE3 in place until the risks of another summer soft patch have clearly abated. Expect QE3 to run through the third quarter. If conditions improve we could see a gradual step down in purchases late this year, otherwise it will roll into 2014. By the way, proportional to the size of their economy, the Bank of Japan’s program of quantitative easing dwarfs the Federal Reserve’s effort.