Disastrous GDP Growth Puts Fed in a Bind
Wall Street cheered news that the economy has slowed to a 2.5% clip during the second quarter of 2006. The headline number sounds great for those pulling for the Federal Reserve to pause in August, but just about everything else in the report was a disaster. Traders focused on news of a slowing economy to push stocks up last week. Considering inflation picked up more than expected in the second quarter, it is somewhat confusing why the markets rallied on such news. But there was something else in the back of trader’s minds that allowed them to bid prices higher. Early last Ben Bernanke stated he believed that evidence we are seeing of a slowing economy would eventually cause inflationary pressures to cool. Predictions of another hike in interest rates fell precipitous last week as continuing signs of slowing economic growth opened the door for the Fed to pause in August.
Outside of the headline figure there are some important key figures found deep in the GDP report. Of most importance is the implication that the economy may actually be in the midst of a recession right now. Almost all of the meager 2.5% growth occurred during April. Over the past three months the economy is expanding at a rate closer to 1% or less. Residential construction showed a 6% decline in activity on annual basis last quarter. Financial Watch expects to see a further deceleration in residential construction during the second half of 2006. Of further concern is a rapid pickup in inflation during this past quarter. The Fed’s preferred measure of inflation well surpassed Bernanke’s stated target zone. Inflation grew at the fastest pace in a decade in the second quarter.
While the markets focused on slower growth last week, Fed officials will need to toe the difficult balance between rapidly slowing economy and unwelcome inflationary pressures. As it stands right now growth in the second half will fall well below sustainable output growth. Unemployment is surely to start to move higher in the coming months and many households that overextended themselves during the housing boom will be forced into financial turmoil. Consumers never slowed down their spending during the last recession, but are poised to do so this time around. Financial Watch honestly believes this is likely the most difficult decision many of the current FOMC officials will ever face. Many on Wall Street believe the Fed is done, but Financial Watch believes they many decide to deliver one final blow to inflation next month. Barring a pullback in oil prices over the course of the next coming weeks inflationary pressures will continue to persist for the intermediate term.
Financial Watch believes this is a prudent time for investors to take advantage of the recent rally to unload positions. Just today, Financial Watch dropped Kohl’s from our list of recommended stocks for 2006 to lock in a gain of 16% year to date. At best stocks will tread water for the next couple weeks.