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What to make of the latest GDP disappointment

August 02, 2012

| MoneyRates.com Senior Financial Analyst, CFA

Last week the Bureau of Economic Analysis (BEA) released an advance estimate of second-quarter 2012 Gross Domestic Product (GDP), and it didn't signal much hope for the U.S. economy.

The estimate indicated that the U.S. economy had slowed from the first quarter's already anemic pace. With no clear solution for breaking the economy out of its rut on the horizon, the era of low interest rates appears likely to continue for a while longer.

A lackluster economic report card

According to the BEA, the U.S. economy grew at an inflation-adjusted 1.5 percent in the second quarter, down from 2.0 percent in the first quarter. The slowdown tracked a falling-off in personal consumption, which declined from 2.4 percent after inflation to 1.5 percent. Most pronounced was a drop-off in durable goods spending, from a real increase of 11.5 percent to a decrease of 1 percent.

Advance estimates of GDP are often off by a fair amount from the final number, but whatever that final number turns out to be, it isn't likely to be pretty.

All eyes on the Fed

With a Federal Reserve meeting scheduled for the week following the GDP announcement, the stock market actually rallied in anticipation of what the Fed might do, but the Fed's lack of action quickly put the brakes on this.

The thinking that bad news is bullish because it will prompt action from the Fed has always been a little perverse, but it is especially so now. It's akin to thinking that it is good that a patient is still sick because now he will get to take more medicine, as opposed to the patient actually getting better.

But even if the Fed had taken more action, it has nothing left but extremely watered-down medicine. It has already taken low interest rate policies to the extreme; it can do little more now than announce that it intends to prolong those policies.

It's unlikely that prolonging policies that haven't worked so far will provide much help for the economy. Indeed, there are at least two reasons to suspect that extremely low interest rates may be counterproductive:

  1. Savers are being robbed of income. Savings and other deposit accounts are paying virtually no interest. With borrowers trying to work their way out of debt, low interest rates haven't prompted a new wave of borrowing, but they have taken income away from savers who might have applied it toward new spending.
  2. Lenders have little incentive to make loans. Consider current mortgage rates, at around 3.5 percent. This is roughly the historical rate of inflation. Why would anyone want to take the risk of lending money for 30 years with no real rate of return in exchange?

It's tempting to think that the Federal Reserve can get the economic engine running smoothly with just a little monetary policy tinkering. In this case, though, it is becoming increasingly clear that the Fed does not have the right tools to fix what is wrong with this engine.

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