What do you think it means when a Federal Reserve Governor (the St Louis Fed Governor – this week) publishes a statement indicating the Fed should begin buying US Treasuries to help stop deflation?   It’s a sign that the Fed sees a weakening economy, that deflation is here, and that they’re out of bullets. In 2009, when the Fed would announce that interest rate would stay low, the stock market rallied because low interest rates force investors back into risky assets (stocks). Now that short term interest rates (the main Fed policy tool) are at zero – and announced repeatedly to stay at zero — there’s not much else the Fed can do to stoke the economy. One of the last things the Fed can do is expand its purchase of US Treasury’s in the hope of lowering longer term interest rates. This lowers mortgage rates and helps encourage home buying. It also reduces interest rates for all manner of bonds. This is a risky and desperate move. It suggests the Fed is more worried about deflation than the risk of exploding inflation in the future (and a rapidly devaluing US dollar). Please keep this in mind as you read the GDP information below…

The big news this week was Friday’s report on 2Q GDP growth.  Stock markets continue to price-in $82 of earnings on the S&P500 index this year, $90+ next year, and 2.5-3% GDP growth for this year and next year. A lot of people going to be surprised when we end up seeing total GDP growth this calendar year at close to zero, and a similarly weak economy next year – with these years joined and punctuated by another recession in the second half of 2010 that carriers into 2011.

Back to Friday’s GDP report. What was expected was 2.5% growth. What was announced was 2.4 % growth. If that headline sounds insignificant to you, you may be forgiven. But a deeper read of the report tells you a very troubling story:

• The report quietly but substantially increased the government’s estimate on the size of the 2008 recession.  Such a major revision does not happen every day. It tells you the so-called Great Recession may have been more damaging than the government initially thought.
• the report revised the previous quarter’s (1Q 2010) growth from 2..7% to 3.7%. But but almost 2.7 of the 3.7% came from a spike in inventory rebuilding. Since we know that is a sporadic event -albeit it may last a few quarters – the government’s data show inventory contribution to economic growth peaking in late Q1 and coming to an abrupt end. It showed the inventory contribution to the economy dropping from roughly 2.7% in the 1st Quarter, to 1% in the 2nd quarter.   At that rate of decline, the inventory rebuild contribution to economic growth will not only be done in the 3Q, it will be subtracting from GDP —further slowing the economy.

The end of October will see the government’s first report on the economy in the 3rd quarter (July-Sept).  By then, the inventory rebuild will have run its course. So I’m expecting to see an overall red GDP number in the -3% range. By that, I mean confirmation that we are now back in a recession and the economy is fairly rapidly shrinking. Recall that any GDP growth rate slower than +2% means unemployment is growing. Imagine what -3% will do. Long before the end of October, we’ll see a steady stream of weakening consumer spending and broad economic data. We’re seeing it now, and it is picking up in pace.

I expected a +1.8% GDP growth figure (+/-) to be announced this week. What was announced was +2.4%. The combined impact of the housing credit, cash for appliance clunkers, and larger (stimulus) tax refunds, drove 1Q GDP up 1% higher than previous estimates, and it drove up the growth rate on the front end of the 2nd quarter as well (April). The BEA is the branch of the government that produces the GDP reports. Their process is antiquated and inefficient. Right now, their first of three estimates on Q2 has just been reported.  They have the most data on the front part of the quarter (more time for businesses to respond). In the case of Q2, that part -April - saw very strong economic growth. But May’s economy weakened, and June’s weakened even more (according to my independent data sources AND the Federal Reserve). So we should anticipate that the next 2 GDP reports in late August and late September (revisions to 2Q’s report) will show more data on the later portion of Q2, and that the +2.4% will end up being lowered.

I began this article with comments from the Fed this week. I’ll finish it with other Fed governor comments this week…..

The Federal Reserve Beige Book was released this week. The Fed’s Beige Book is a report on economic and business conditions from each of the 12 Fed District central banks, and happens 8X a year. The latest report was for the period for June and early July and was the weakest report this year. Within the report, the Dallas Fed showed an economy that was the weakest since July last year.   The Chicago Fed report showed the worst economic data since October last year. In fact, according to the Chicago Fed data, we never actually came out of a recession.     From the point of view of several Fed districts, the report showed the economy is seeing deflationary pressures, orders falling, and profit margins coming under pressure. That means earnings are going to be under pressure next earnings season  —3 months from now.