Economic Watch: GDP Eases Back as Fed Looks to Rate Hike

Economic growth in the U.S. lost a good portion of its momentum in the third quarter, according to a new Commerce Department report, but the performance may still be strong enough for the Federal Reserve to push interest rates higher before the year is out.

The gross domestic product (GDP) increased at an annual rate of 1.5%. This advanced estimate of the total output of the nation’s good and services compared to a rate of 3.9% in the second quarter.

The latest figure is the first of three estimates. While far better than the 0.6% rate in the first quarter of the year, it is well short of the 5% pace in the third quarter of 2014.

The deceleration in the GDP during the third quarter primarily reflected a downturn in private inventory building and easing in exports, nonresidential fixed investment, personal spending, state and local government spending, and in residential fixed investment, according to the department. These were partly offset by a deceleration in imports (imports are subtracted when calculating GDP.)

During the third quarter, businesses spent about half the amount of money they did in the second quarter in building up inventory, cutting nearly 1.5 percentage points off the GDP in the third quarter.

Consumer spending, which accounts for about two-third of all economic activity, increased at a 3.2% rate compared to 3.6% in the second quarter.

Disappointment in today’s advance report is tempered by the fact that it was largely accounted for by a slower pace of inventory building, said Nathan Janzen, economist at RBC Economics.

Inventories were higher than they should be after the first half of the year, when businesses ordered extra because of concerns about transportation capacity, slowdowns at ports, etc. The lower third quarter inventory-building is simply a reflection of businesses trying to get inventories back to normal levels. That lower inventory-building also contributed to a slowdown in truck freight during the quarter.

“The drag from this volatile component is not likely to be repeated with any potential reversal, providing an upward support going forward,” Janzen said. “Net international trade is unlikely to provide much support in the near-term given some uncertainty about external demand growth and a stronger U.S. dollar. However, with the domestic economy continuing to improve, this still argues for growth in GDP to rebound in the fourth quarter, with our current forecast assuming a 2.9% increase in the quarter.”

Federal Reserve Feeling Slightly More Bullish

The GDP report comes on the heels of the U.S. Federal Reserve's two-day policy meeting, in which the Federal Open Market Committee decided to leave interest rates near zero for the 83rd straight month. However, the committee sounded slightly more bullish, according to RBC Economics.

“The committee upgraded its assessment of consumer spending and investment, dwelled little on the slowdown in employment growth, and altered its forward guidance to emphasize that a December hike remains on the table,” said Josh Nye, RBC Economist. “These developments gave the statement a slightly more bullish tone compared with September."

Policymakers see the consumer and businesses on slightly firmer footing.

However, this positive nugget was more than offset with the “slow” assessment of hiring, according to Lindsey Piegza, chief economist at Stifel Fixed Income.

“Does this sound like a Fed gearing up to raise rates in the next eight weeks? To be fair, they certainly haven’t closed the door on a rate increase in December. There was no calendar specific text specifying 2016 or later, as there never is,” she said. “However, in order to justify a rate increase, the first rate increase since 2006, the economy should be sending crystal clear signals that it is ready and able to withstand a rising rate environment.”

She said with noticeable weakness across much of the economy, including the two key sectors determining monetary policy – the labor market and inflation – without a material reversal in the currently sluggish trends near-term, policymakers will have an increasingly difficult time justifying a rate increase come mid-December.

By then the Fed will have had the opportunity to see updated third quarter GDP numbers along with several other economic reports, which could finally push them to hike the interest rates. Or not.