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Economy in Brief

Fed Chairman Powell's First Test--Fiscal Stimulus Boosts Q2 Nominal GDP to Its Fastest Growth Rate Since 2006
by Joseph G. Carson (jcarson21@aol.com)  July 30, 2018

Federal Reserve Chairman Jerome Powell's first test of deciding over the proper stance and course of monetary policy has arrived. Back in February when Mr. Powell testified before Congress he said one of the more important factors influencing the economic outlook would be the tailwind from fiscal policy, which up to then had been a major headwind. Well that day has arrived, probably even sooner than Mr. Powell expected.

In Q2, Nominal Gross Domestic Product (GDP) soared at annual rate of 7.4%, with real output advancing 4.1% and GDP prices increasing 3.2%. The second quarter burst pushed the 12-month growth in Nominal GDP to 5.4%, the fastest growth rate since 2006. It’s hard to quantify how much of the relatively strong advance in nominal consumer spending (5.9% annualized) and business spending on equipment (4.8% annualized) stemmed from recent reduction in federal taxes. But its safe to say there was a positive influence, with more to come.

Yet, the biggest and most direct impact from the shift in fiscal policy was clearly evident in federal spending. In Q2, nominal federal government spending advanced at annual rate of 5.6%, which comes on the heels of a 4.5% gain in Q1. Both quarterly gains represent a dramatic reversal from the trends of the past 7 years.

Indeed, since 2010 nominal federal government spending, which accounts for roughly 10% of overall GDP, has been held in check as Congress enacted spending caps on defense and non-defense discretionary spending. In fact, during the 7-year stretch from 2010 to 2017, nominal federal spending in the GDP accounts did not increase, which by itself imposed a huge and persistent drag on overall economic activity.

However, in February, Congress not only voted to remove the spending caps but they replaced them with a two-year plan that boosts spending on defense and domestic programs by $300 billion. As a result, nominal federal government spending, which is currently running at a 5% growth rate in the first half of 2018, should be able to be at least sustain that growth rate through the early part of 2020.

The 500 basis point increase in the growth rate of federal spending represents a dramatic change in the stance of fiscal policy, which policymakers have to recognize along with the reduction in federal taxes as well. Of the two, the increase in federal spending is probably the most important for policymakers as planned appropriations by Congress are guaranteed to feed directly into the economy lifting the nominal growth path and potentially increasing the inflation tendencies in the overall economy as well.

The 3.2% annualized increase in GDP prices in Q2 represented the largest quarterly increase since 2007, and was driven by relatively fast price increases in residential and non-residential structures, merchandise exports and government services. While the Fed explicitly targets consumer prices other prices from business and trade still yield important information on the character of the economy.

Federal Reserve policymakers have been planning to gradually lift official interest rates through the end of 2019. Yet, now with tailwind of fiscal policy in train policymakers need to not only rethink the pace of official rate increases but also the scale. History shows that when economy is running with a nominal GDP growth rate of around 5% a neutral rate of the federal funds rate is between 4% and 5%, well above what policymakers have currently penciled in for the peak rate over the next two years.

When testifying before Congress in July Mr. Powell stated, “our actions will depend on the economic outlook, which may change as we receive new data.” Q2 GDP is new data and it gave policymakers the first glimpse of how fiscal stimulus is lifting nominal GDP growth and inflation. Mr. Powell's first test as Fed Chair has arrived and he needs to steer the ship towards a higher fed funds path soon.

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