Did The Fed Have Their Hands In the Cookie Jar?
Last Wednesday, an hour before trading began, the Government released the latest result for the Nation’s Gross Domestic Product. It is the critical number that everyone on Wall Street waits for. GDP is the total of the entire country — the definitive measure of all the goods and services produced during the latest quarter.
The Bureau of Economic Analysis puts together all the components, which can take some time. You can imagine how difficult it is to gather together all of the various inputs from our economy. So, to accommodate investors, government agencies, and news bureaus, the BEA takes three stabs at estimating GDP. The first is very preliminary, which the BEA calls the “Advanced” Estimate.
In Wednesday’s report, the BEA’s second estimate showed a more robust economy than they previously thought. The BEA now estimated that the economy rose by 5.2%, 3/10% higher than their initial report. It’s big news; we haven’t seen this solid economic growth in 20 years! Investors were pleased. Indeed, the President and his Administration were glad to, and the News Bureaus all led with the story of economic growth.
However, at this point, a puzzle emerged. Some more enterprising analysts noticed that the Gross Domestic Product did not equal the Gross Domestic Income (GDI). While the Product advanced at an annual rate of 5.2%, Income was up only 1.5%. The difference between the two measures is 3.7%. It’s one of the most significant differentials anyone can recall.
As any accountant or bookkeeper will tell you, that shouldn’t happen. On any valid Income Statement, the Product sold (GDP) should always equal Income (GDI). The fact that these two items are currently out of balance by such a significant amount is disturbing.
This differential between Product (GDP) and Income (GDI) created a real stir on Wall Street. Bloomberg and Zero Hedge, in particular, noted the aberration. But, as is often the case in our 24-hour news cycle, information may be plentiful, but analysis is increasingly rare. The following story beckoned, and the reporters were quick to move on.
But there is an essential insight into how our economy is currently operating, and it lets you and I take a more in-depth look.
The first thing we must understand, which will come as no surprise to my readers, is that our nation’s economy doesn’t operate in the ideal world that our accounting systems envisage. While you and I must use it within the boundaries of proper accounting principles, the national economy doesn’t. Every time we produce an income statement or file our taxes, our “Product” (i.e., sales) MUST equal our Income. To do otherwise would be considered fraud. The IRS believes strange money appearing or disappearing from an income statement is criminal. After all, this is how they caught Al Capone, unreported Income.
However, at the national level, the level of the GDP report, money enters and exists in the financial system repeatedly. We sanitize these operations with such benign labels as “stimulus,” “quantitative easing,” or, my favorite, “accommodative monetary policy.” The more syllables, the better the underlying strategy!
We begin by examining the past ten years of the nation’s GDP history. You’ll note that nothing here resembles the traditional “business cycle” as described in the average College textbook. Those graphical sine waves of recession, recovery, expansion, peak, and recession again are missing. There are no even up-down cycles at all. Instead, this last decade shows periods of fits and starts, when the economy barely avoids falling into recession and is followed by spurts of short anemic expansion. Nothing here resembles a “normal” business cycle.
Of course, you can’t help but notice that extremely volatile period from 2019 through 2022. It was the period of the COVID-19 Pandemic. And while COVID may describe the disease, the Government’s actions caused the wild swings in the economy. The most destructive economic policy ever instituted in the US was the “lockdown” and isolation policies first seen in early 2020. For one brief quarter, Q2 2020, the death toll was sounding, the economy dropping further and faster than ever before.
Our second chart adds the Gross Domestic Income (GDI) dimension. Here, you’ll note that Income declined at the very beginning of 2019, well before the COVID-19 disease came to America. Someone or something is removing Income from the economy. As you know, that something was the Federal Reserve. The nation’s central banker operates under the twin Congressional Mandate of Stable Prices and Full Employment. But recently, the Fed has taken more and more responsibility for the economy’s performance.
As the Fed expands its role as “controller of the economy,” we see more and more instances of funds entering and exiting the financial systems. The Fed provides liquidity to the nation’s banks or removes liquidity. The Fed raises interest rates to slow the economy or lowers them to provide Stimulus. And in some extreme cases, like the recovery from COVID, the Fed sends cash directly to citizens and businesses. These actions make it almost impossible for the accountants to keep up. What ledger item does “funds from nowhere” go under?
When money falls from the sky, as in the Stimulus, it’s hard to enter that on a balance sheet.
Our final chart adds interest rates to the complex. This chart consists of GDP, GDI, and now the Fed Funds and short-term interest rates. Remember, the Fed raises interest rates to slow the economy and lowers rates to provide Stimulus. While we did not see a business cycle in the GDP chart, it is clear that the Fed has been through several financial cycles over the last decade.
Ten years ago, the Fed was on the most accommodating interest rate policy in its history, with interest rates at essentially zero. Beginning in late 2015, the Fed started to tighten system liquidity by raising interest rates. The Fed continued to raise interest rates (tightening) for the next four years, at which point the Fed also withdrew liquidity (quantitative tightening, selling off bonds in its “balance sheet”). Only after these two tightening strategies (higher interest rates, reducing Fed Balance Sheet) do the economy (GDP) begin to tumble. Please observe that the economy was well on its way to recession BEFORE the COVID-19 Pandemic struck.
When COVID strikes the Fed, it then reverses everything. The Fed then cuts interest rates back to essential zero, and this time, the Fed increases liquidity; seven trillion dollars enter in the form of Stimulus. Income falls only slightly (offset by Stimulus) annually while the GDP plummets. It’s the beginning of the accountant’s nightmare. Income materialized from nowhere, while the economy had the worst quarter since the 1930s. Income and Product need to be balanced. It becomes apparent why Wednesday’s GDP Report showed Product growth of 5.2% while GDI showed income growth of only 1.2%. Income never really fell, so any current improvement will be marginal, while Product plunged, and any return to normal would be significant.
Any thorough review over these past ten years points to the role of the Federal Reserve in controlling our economy. When the Fed desires a more robust economy, it can provide lower interest rates and more liquidity, as before 2015 and from 2020 until 2022. When the Fed wants to slow the economy, it raises rates and withdraws liquidity as it did from late 2015 until 2019 and as it is doing currently. This later move has been motivated by the Fed’s desire to curb inflation.
Seemingly benign, these moves can profoundly affect the overall growth of GDP. And hence the livelihood of millions of Americans. While it’s true that many Americans, and virtually all Accountants, feel that this country operates as a legitimate, free, and open economy. In reality, the Fed is busy behind the curtain, adding or subtracting money, much like an old Mob Boss. The fact that the latest GDP Report does not balance demonstrates that.
