InvestorQ : How do you see the US GDP growth in the second quarter impacting how rates are set?
swati Bakhda made post

How do you see the US GDP growth in the second quarter impacting how rates are set?

Sam Eswaran answered.
2 months ago

It is just the RBI but even the US Federal Reserve is fighting a tough battle trying to balance growth and inflation. On 25th August, the US Bureau of Economic Analysis (BEA) put out on its website the second estimate of the US GDP for June 2022 quarter. For the US economy, the June ending quarter is the second quarter since they follow the calendar year system. The US Real GDP for the June 2022 quarter contracted by -0.6%, but the good news was that this contraction was less than the -0.9% pegged in the first estimate.

Like in any GDP report, it was a mix of positive and negative factors that worked on the US GDP. There were some factors that created strain and some that mitigated this strain. Let us quickly look at some of these factors. The pressure on imports came from higher imports and lower retail inventory. However, this impact was partially extenuated by improved export of travel services and also a sharp surge in consumer spending. What is important is that second estimate of Q2 GDP is 100 bps lower than Q1 Real GDP contraction of -1.6%.

One factor we need to appreciate here is that the real driver of negative real GDP growth in the second quarter was the high levels of inflation. After all, real GDP is nothing but the nominal GDP adjusted for the price multiplier. For instance the nominal GDP (before inflation) was up 8.4% for the second quarter. However, the entire nominal GDP growth and more was nullified by high levels of inflation, resulting in negative real GDP. That is why, the Fed is so intent on first reining in inflation.

Even as markets were complaining about negative GDP, the US Fed had been reassuring them that the consumption side was more reflective than the production side. That is the reason, the Fed considers private consumption expenditure (PCE) driven inflation for its rate policy rather than looking at consumer inflation. PCE inflation has been static at 7.1% for Q2 showing that consumption is still robust. By that parameter, the Fed policy should continue to be hawkish for some more time from here. That is due to post COVID largesse.

How will Powell and the Fed members react to this data point. The stand of the Fed and Powell will be clear in the Jerome Powell speech at the Jackson Hole Symposium on Saturday. However, if you recollect, the Fed has been emphatic that the key decision point would still be inflation and the latest data is not likely to change that. It could also imply that the Fed is still going to front load rate hikes and even touch 3.75% in 2022 itself. At least, 2022 may still remain hawkish, although there could be a turn in 2023.

Should the RBI have any concerns over the US GDP data? There are going to be two sides to this coin; one positive and one negative. The strong nominal growth in GDP shows that the US economy is still robust and tech spending will remain robust for the time being. On the other hand, the RBI may apparently not stop at 5.4% if the Fed holds its hawkish stance and that looks like the most likely scenario. It now looks like the terminal repo rate for the RBI may not stop at 5.4% but perhaps get closer to the 6.5% 2019 mark.