'Tis The Season For Seasonal Obfuscation

Submitted by Jeff Snider of Atlantic Capital Management

'Tis The Season For Seasonal Obfuscation

The headline GDP number was apparently enough growth to completely erase all thoughts of any renewed recession.  However, most of us know that one quarter is not a trend and that the quarterly numbers are often statistically adjusted beyond something non-statistically meaningful.

If we look at the headline numbers in sequence, it certainly seems that the economy is picking up from the weak first half (not a full hockey stick, but close enough for economist types):

Seasonally Adjusted Real GDP at annual rates

Q4 09        Q1 10     Q2 10     Q3 10     Q4 10     Q1 11     Q2 11     Q3 11
   3.8%      3.9%      3.8%       2.5%       2.3%     0.4%      1.3%      2.5%

From these numbers it looks as if the economy slowed in the middle of 2010, hit a bottom in the first quarter of 2011, and has rebounded through the rest of 2011.  I have little doubt that the economics profession has assumed a lagged effect from monetary stimulation, meaning the data largely confirms QE’s stated goals.  From this interpretation, it looks as if Bernanke and his crew were exactly right to begin just when conditions were deteriorating and we are now set to bask in the successful afterglow of monetary intervention.

A funny thing happens, though, when you remove the seasonal adjustments.  Rather than depend on the BEA’s statistical “improvements” to the data series, you can simply compare the data year-over-year (bypassing the seasonal adjustments):

Real GDP, y/y change at annual rates

Q4 09        Q1 10     Q2 10     Q3 10     Q4 10     Q1 11     Q2 11     Q3 11
  -0.5%      2.2%     3.3%       3.5%       3.1%     2.2%      1.6%      1.6%

This data presents an entirely different picture of the economy.  From this point of view, GDP growth peaked toward the end of 2010 (just when QE 2.0 was announced) and has been decelerating ever since.  This actually makes more sense given the next data series:

Price Index, Gross Domestic Purchases, y/y change at annual rates

Q4 09        Q1 10     Q2 10     Q3 10     Q4 10     Q1 11     Q2 11     Q3 11
  0.6%       1.6%     1.6%       1.4%       1.4%     1.9%      2.6%      2.9%

The economy’s deceleration matches perfectly the increase in the price index, the BEA’s uneven proxy for inflation.  Intuitively this makes far more sense, and from that we can draw far different conclusions about the efficacy of monetary interventions.

Of course, all caveats apply here, namely that none of these numbers are without difficulties and exhibit far too many assumptions to be considered very accurate descriptions of what is happening.  The point of using them here without further questioning their validity is that even based on these faulty and reconfigured numbers the economy appears to be heading in the wrong direction for the exact reason that many of us have believed from the start.  Even using the establishment’s own numbers, we see the same picture that we have received from other sources.  The only backward correction we have to make is to discard the seasonal adjustment, something that seems to be confusing a lot of economic series data lately.

Of course, it stands to reason that if we take the view that the deflators the BEA use statistically, imputationally or otherwise undercount the severity of price changes, then the economy is in even worse shape right now (which is very likely).  But, again, the quarterly snapshot is not really what is important here, it is the undeniable downward trend in GDP, due to the undeniably upward trend of inflation (even going by the most conservative and doctored estimates of it).  If inflation is going to become “transitory”, it had better transit to another state relatively soon.

Within the internals of GDP, we see that five categories of activity account for 84% of all growth in the third quarter:  personal service spending on housing and utilities, personal service spending on health care, plus non-residential investment in industrial equipment, transportation equipment and “other” equipment.

Those business investments in various equipment together made up 45% of Q3 2011 GDP growth.  Business equipment spending has been one of the few sources of “strength” in this recovery, simply because the scale of the decline during the Great Recession was massive.  In other words, these are likely investments that were put off or delayed by the financial and liquidity conditions of the 2008/09 time period, and therefore are not necessarily investments undertaken due to expectations for future revenue growth. 

The fact that equipment spending exhibits the same decelerating trend as overall GDP means that inflation is not only taxing consumer spending, it is working its way into business investment and businesses’ expectations about future needs:

GPDI in Equipment and Software, y/y change at annual rates
Q4 09        Q1 10     Q2 10     Q3 10     Q4 10     Q1 11     Q2 11     Q3 11
 -5.8%      8.5%      15.5%    17.6%      16.6%    13.4%      9.2%     10.0%

The other drivers of growth, the primary force behind the higher than expected PCE number, spending on personal services bring up all sorts of additional questions.  The fact that spending on health care alone accounted for 0.61% of the overall 2.5% GDP growth is far more questionable than commendable. 

Housing and utility spending are also not the kinds of expenditures that lead to a robust and self-sustaining recovery.  What we won’t know until the second revision is how much of this estimated increase in housing spending was for utilities, how much was for rent, and how much was due to the BEA’s imputation of owner’s equivalent rent.  If it was rent, that is problematic as it would suggest that the “benefits” of strategic default/squatting might be winding down.  If it was the owner’s equivalent rent line, then it is simply fiction (the BEA estimates what a homeowner would pay to himself if he rented the house he lives in from himself, as if this is real economic activity to be included – and this is not a small imputation either, totaling about $1.2 trillion of GDP – so any increase in this line is, by definition, fantasy).

The 1.7% drop in real disposable income, and the subsequent drop in the savings rate, means that the downward trend in overall activity may be about to accelerate (third derivative changes outrank second derivatives).  Rather than cheering this economic report, the market should be questioning its call for more inflation engineering (I suppose intentional dollar devaluations that drive overseas profitability at the expense of the domestic economy is a rational investment thesis on some level).

Mainstream economists really believe in the Paradox of Thrift; that what is best for individuals (repairing their own balance sheet) is not the best course for the overall economy (because balance sheet reparation necessarily means less activity).  Monetary policy has intentionally created inflationary expectations to get households out of their “bunker mentality”, making the cost of holding money or saving expensive or unattractive.  This includes a dangerous comfort level with rising oil and energy prices (see Federal Reserve Board’s Research Paper “Oil Shocks and the Zero Bound on Nominal Interest Rates” published in September 2010).  Coupled with the “wealth effect” and ZIRP, the Fed actually believes it can create “rational expectations” of a robust future, thereby essentially fooling households and consumers into undertaking activity that is not in their own best interests.  This is what passes for a recovery plan today. 

That this convoluted scheme is actually expected by policymakers to work is beyond distressing.  That we have to strip away the mathematical manipulation of the headline data to see this at work is unsurprising.  This drop in the personal savings rate is actually welcomed by mainstream economists as a positive sign that monetary policy might be working, but the world is not an academic model.  One has to wonder just how bad all these figures would be if they actually used Brent or Louisiana Light Sweet prices instead of WTI, but, unfortunately, such arcane observations of the unadjusted real world are beyond the capabilities of modern economic and monetary science. 

The real recovery begins when sanity and logic are implemented or injected into monetary policy.  The Paradox of Thrift, the Wealth Effect, and Rational Expectations should all end up on the ash heap of history.  Removing ZIRP alone might be enough to actually begin a real recovery.  Until then, however, they can change the seasonal adjustments all they want, but the story remains the same.