Wednesday, January 31, 2007

Goldilocks in the House

The advance report on GDP for the 4th quarter 2006 was reported at +3.5%, better than the 3% expected by economists:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 3.5 percent in the fourth quarter of 2006, according to advance estimates released by the Bureau of Economic Analysis. In the third quarter, real GDP increased 2.0 percent.

The 2% growth in the 3rd quarter had convinced most that the economy would continue to slow forcing the Fed to cut rates. We argued in our last two Tactical Updates that the economy was unlikely to fall into recession:

Betting against the US economy has been a poor bet over the last 30 years and we are generally optimists about the US and world economy....We think a more likely outcome is that the economy re-accelerates and interest rates rise sometime next year.

In addition to good news about growth, the inflation numbers reported along with the GDP report were exceptionally good as well:

The price index for gross domestic purchases, which measures prices paid by U.S. residents, increased 0.1 percent in the fourth quarter, compared with an increase of 2.2 percent in the third. Excluding food and energy prices, the price index for gross domestic purchases increased 2.3 percent in the fourth quarter, compared with 2.2 percent in the third.

We also predicted this in a previous Tactical Update:

A slowdown to a more sustainable pace would actually be quite welcome as it would ease the pressure we’ve seen on natural resources (commodities) and tend to reduce inflation.

Obviously, most of the moderation in prices in the fourth quarter was due to falling energy prices as the ex food and energy numbers were in line with the previous quarter.

Another theme we have stressed is the deflationary effects of globalization and that can be seen in this report as well. Import prices fell 8.5% in the fourth quarter which probably contributed to an overall drop in imports of 3.2%. Exports were up 10%. So much for all that worrying about the trade deficit.

The big drag on the economy continues to be housing as real residential investment fell 19.2%. This was partially offset by an increase in non residential structures of 2.8%. Another drag was inventories which only increased $35.3 billion in the quarter vs $50 billion plus in the last two quarters. This may mean an added inventory build in the first quarter that will add to growth.

Overall, it seems that the Goldilocks economy is back. We continue to believe that the Fed is on indefinite hold. We see no reason to expect a rate cut or hike in the near future. We'll get a little more info this afternoon when we parse the Fed statement. We also expect growth and corporate profits to continue to surprise on the upside.

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