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Why the Fed lowers the economic speed limit

Brent Nyitray, CFA, MBA

Overview: Analyzing the July 2014 FOMC minutes (Part 2 of 6)

(Continued from Part 1)

Lower economic speed limit

The Fed noted that the first quarter was very negative. This was caused by bad weather, but that economic growth has bounced back in the past few months. The economy rebounded in the second quarter. However, overall growth for the first half of the year was only “modest.”

In terms of the economic forecast, the Fed took down its estimate for unemployment and future gross domestic product (or GDP) growth.

The most important quote from the minutes was “To reconcile the downward revision to real GDP growth with an unemployment rate that was now closer to the staff’s estimate of its longer-run natural rate, the staff lowered its assumed pace of potential output growth this year by more than it marked down GDP growth. As a result, resource slack in this projection was anticipated to be somewhat narrower this year than in the previous forecast and to be taken up slowly over the projection period.”

This quote is important because it means that the Fed believes the slack in the labor market is less than previously forecast. What this means is that many long-term unemployed are probably going to stay unemployed. In other words, the Fed doesn’t consider them “long-term unemployed”—it considers them “retired.” In many ways, this is the Fed’s admission that it’s giving up on the long-term unemployed. However, it’s debatable how much influence the Fed funds rate could have on the situation in the first place.

Another implication is that the economy’s “speed limit” has been lowered. This means that inflation will be an issue sooner than people would like. Before, inflation may not have kicked in until GDP growth was 3.5% and unemployment was 5%. Now, the estimate might be GDP growth of 3% and unemployment of 5.3%. Of course, all of this is questionable until we see actual wage inflation. However, this is what the models are saying.

Implications for homebuilders

Overall, the data suggests that the economy will continue to improve. This will be good for builders like Lennar (LEN), PulteGroup (PHM), D.R. Horton (DHI), and Toll Brothers (TOL). Investors who want to invest in the sector as a whole should look at the S&P SPDR Homebuilder ETF (XHB).

Continue to Part 3

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