USA Outlook Update (July 28, 2006): GDP of second quarter of 2006, and the prospect of inflation and interest rate

Preliminary estimate of GDP of the second quarter of 2006 is announced today along with substantial revisions dating back to the first quarter of 2003. The erratic behavior of defense spending in the third and the fourth quarters of 2005 has been smoothed out somewhat. Real GDP grew at the rate of 2.5% a year. This slower growth rate than the first quarter of 2006 is expected after the sizzling growth rate of 5.6% a year in the first quarter. The question is whether this 2.5% growth rate is slow enough to curb future inflation so that FED can now stop its tightening move. The US consumers did not show any sign of retreat in the second quarter from their spending habit. The slower real GDP growth in the second quarter was due to the slower spending by businesses, a completely opposite to the views of many financial observers. If we look at the nominal (before inflation adjusted) values, personal consumption expenditure expanded at 6.6% annual rate, compared to 6.8% in the first quarter, and the average of 6.9% from the 4-th quarter of 2004 to the 3rd quarter of 2005; this is done to eliminate the extra slow quarter of the 4-th quarter of 2005, otherwise the average growth rate of 2005 was only 6.0%. According to the monetary indicator used in Comment 31 that is the difference between the growth rate of nominal GDP (+5.7% for the second quarter of 2006) and the Federal Fund's rate, FED's monetary policy is still slightly accommodative. In the meanwhile the annualized inflation gauge used in the GDP report is holding steady at the level of 3.3% a year for the past 5 quarters. Considering those facts, we believe that it is necessary for FED to continue its tightening move by boosting Federal Fund's rate to about 6% in order to prevent future inflation surge. Even if FED decides to pause its tightening move for a few months, it will be forced to reengage in the gradual tightening move by the creeping inflation presssure.