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Quick thoughts on GDP: more stagflation




Third quarter real GDP growth was a bit stronger than expected (2.0% vs. 1.8%), but to me that was not the big news of the day. The more significant "beat" in the data was the GDP deflator, which came in at 2.9% vs. expectations of 2.1%. The combination of the two pushed nominal growth (on a quarterly annualized basis) up from 2.8% in the second quarter to 5.0% in the third quarter. With the exception of only 3 of the 13 quarters since the recovery began, nominal GDP growth has been 4% or better. We are a long way from facing any threat of deflation, and it should be abundantly clear that there is no shortage of money.


From a long-term perspective, this continues to be the weakest recovery ever. As the chart above suggests, the economy is about 13% smaller than it could have been absent the deep recession and the very meager recovery. That is equivalent to a little over $2 trillion of national income that has gone missing, and that accounts for at least half the size of the current federal deficit. In other words, the tax base on which current tax rates are applied is a lot smaller than it could have been. 


The chart above shows the quarterly annualized rate of inflation according to the GDP deflator. The economy flirted only briefly with inflation late last year and in the second quarter of 2009, but other than that it looks like inflation is on track to be 2-3% going forward. This casts further doubt on the Fed's commitment to keep inflation low, since currently they are pursuing an obviously reflationary strategy at a time when inflation is at or above their target. It's not difficult to conclude that they are giving much greater weight to their full employment target at the expense of their inflation target.

This new inflation reality also clashes head-on with the yields on Treasuries. 5-yr yields are a measly 0.8%, 10-yr yields are a paltry 1.8%, and 30-yr yields are 2.9%. Negative real yields on everything out to 10 years mean that savers are being cheated and borrowers and speculators are being rewarded. The incentive to save is low and the incentive to speculate is high, and that is not a prescription for healthy economic growth. Erratic and inflationary monetary policy thus gets some of the blame for the slow growth of recent years. I worry that if the Fed keeps short-term rates close to zero for the next few years, as they promise, we could face a serious inflation problem in the next 3-5 years.

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