Economists were rattled on Thursday after new data revealed evidence of persistent inflation and slowing growth in the US. Real gross domestic product (GDP) rose just 1.6% year over year in the first quarter, the Bureau of Economic Analysis reported Thursday. That was well below economists’ consensus forecast for growth of 2.5% and a significant decline from the 3.4% growth in the fourth quarter of last year.
Meanwhile, the Federal Reserve’s most popular inflation indicator – the core personal consumption expenditures (PCE) price index, which excludes more volatile food and energy prices – rose from 2% in the fourth quarter of 2023 to 3.7% in the first three months of this year, well above the Inflation rate is 2.1%, which was predicted by the Survey of Professional Forecasters in February.
“This was the worst report of both worlds — slower-than-expected growth, higher-than-expected inflation,” said David Donabedian, chief investment officer of CIBC Private Wealth US Assets by email.
Donabedian argued that the “biggest setback” is the rise in core inflation, particularly in the services sector, where consumer price increases are topping 5% a year. For Fed Chairman Jerome Powell and his central bank colleagues, who had hoped inflation would ease to lower interest rates and stimulate the economy, this new data means more difficult times lie ahead. “We are not far away from supporting all rate cuts contrary to investor expectations,” Donabedian said. “It forces Chairman Powell to adopt a hawkish tone for next week’s FOMC meeting [Federal Open Market Committee] meet.”
Citi economists led by Veronica Clark echoed that sentiment in a note Thursday, arguing that the Fed’s favorite inflation gauge is likely to rise to 2.8% when March data is released on Friday, prompting central bank officials to a more restrictive attitude. As a result, Clark and her team now expect the first rate cut to occur in July instead of June. “But we still believe markets are making a mistake by pricing out cuts in full this year,” she wrote.
With fiscal stimulus support waning and goods spending weaker, concerns about economic growth will ultimately weigh on the Fed as it decides whether to cut interest rates or keep them elevated. “We still expect the Fed to cut this summer before inflation has slowed sustainably,” Clark said.
But investors were clearly focused on hints of stubborn inflation in Thursday’s first-quarter GDP report and appeared less enthusiastic about the chances of market-boosting interest rate cuts this summer. The Dow Jones Industrial Average fell 1.5% by midday Thursday as investors digested the first-quarter GDP report, while the S&P 500 fell 1.1% and the tech-heavy Nasdaq Composite fell 1.5%.
After many leading Wall Street forecasters and economists recently adopted a new outlook for the U.S. economy – a “no-landing” scenario with more robust economic growth and slightly higher inflation – EY chief economist Gregory Daco argued that the GDP report for The first quarter also destroyed this theory. “This report refutes the misleading narratives of a reaccelerating economy,” he said Assets by email.
Daco said he believes economic growth will cool further in the second quarter due to “stubborn inflation,” tight credit conditions and weaker labor demand. “And we emphasize that if inflation proves more stubborn than expected, the downside risk to the economy could be significant due to reduced real income growth, a ‘longer-term higher’ Fed stance and tightening financial conditions,” he said.
David Russell, global head of market strategy at TradeStation, even argued that the US economy could be facing an economic nightmare scenario not seen since the 1970s.
“Stagflation is a growing risk following GDP misses and price index surprises to the upside,” he said Assets by email. “If inflation doesn’t improve with such weak growth, you have to wonder whether the trend of lower prices will continue.” This theory was confirmed by Jamie Dimon, CEO of JPMorgan Chase, who told the Wall Street Journal This week we noted that stagflation is a risk the Fed cannot ignore.
A caveat about the weak GDP data
While the first quarter GDP report was undeniably worrying, there were some reservations about the weak growth statistics. First, private domestic demand, a measure of real final sales of domestic purchases, actually increased by 3.1% in the first quarter. “The 3.1% growth in real private domestic investment is encouraging as it tends to be a strong leading indicator of future near-term GDP growth,” William Blair analyst Richard de Chazal said in a note on Thursday.
Spending on health care, finance, insurance and other services also continued to rise in the first few months of this year, even as spending on goods slowed, showing that underlying demand metrics remain robust.
Paul Ashworth, chief North America economist at Capital Economics, said in a note Thursday that rising U.S. imports relative to exports continued to significantly reduce GDP growth in the first quarter, masking signs of underlying economic momentum.
“Exports ended up just 0.9%, highlighting the impact of weak global demand, while imports rose 7.2%,” he explained. “Overall, net exports detracted from GDP growth by almost 0.9 percentage points, with inventories causing an additional drag of almost 0.4 percentage points.”
These reservations suggest that the economy was fundamentally stronger than first quarter GDP growth figures showed. That’s a good sign for consumers and businesses, but it will also deter the Fed from cutting interest rates — at least “for now, as demand is broadly OK but inflation is still uncomfortably high,” he said de Chazal by William Blair.
This story was originally published on Fortune.com