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The first quarter GDP report surprised investors with disappointing growth while consumer prices continued to rise.
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This sets the stage for stagflation, which cannot be combated by cutting interest rates.
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The 1970s warned of what could happen if inflation got out of control.
The latest GDP and inflation numbers were what investors were least excited about and could signal serious problems ahead.
“This was the worst report of both worlds – slower-than-expected growth, higher-than-expected inflation,” wrote David Donabedian, chief investment officer of CIBC Private Wealth US.
According to the Bureau of Economic Analysis, growth in the first quarter fell well short of estimates, rising at an annual rate of 1.6%. Not only is this well below forecasts of 2.5%, but it will also fall short of the 3.4% increase achieved in the fourth quarter.
While such a slowdown would normally increase calls for a rate cut, the report also found a larger-than-expected rise in consumer prices. This significantly limits the Federal Reserve’s ability to act, as the central bank has made it clear that inflation must fall before interest rate cuts can occur. Stocks that had long priced in these cuts sold off sharply.
It’s also bad news for the economy, as stuttering growth and higher prices are the main factors driving stagflation, which is characterized by economic listlessness and stubbornly elevated inflation over a prolonged period. Such a scenario may be even more difficult to combat than a recession because of the dynamics described above: the Fed’s hands are largely tied.
America’s last play with stagflation occurred in the 1970s. The precedent can provide insight into how the U.S. economy may evolve and makes clear why economists are keen to avoid a repeat.
At the start of the decade, geopolitical disagreements led the OPEC coalition to restrict crude oil exports to the United States, causing energy prices to skyrocket. With additional help from heavy government spending and the dollar’s decoupling from gold, inflation rose to double digits while the economy slumped.
The period was so turbulent that it overturned longstanding macroeconomic theories and forced the Fed to increase its role in the economy. To finally get the situation under control, then-Fed Chairman Paul Volcker was forced to raise interest rates by an incredible 20%, which calmed price highs but plunged the US into a deep recession.
This is why today’s analysts cringe at comparisons to 50 years ago, and this is why stagflationary forecasts carry weight.
JPMorgan’s Jamie Dimon is among those who have recently made references to the stagflationary 1970s and warned that markets have become too optimistic about the economy.
“I’m worried that it’s looking more like the ’70s than ever before,” the prominent bank boss said last week at the Economic Club of New York.
His point – which he has emphasized several times – is based on the fact that government spending has exploded again while the economy is suffering from a range of inflationary drivers: from green industrialization to global remilitarization.
But stagflation remains a long way off. Despite persistently high inflation, markets continue to price in at least one interest rate cut this year. Additionally, after the GDP report, Barclays analysts led by Pooja Sriram noted that final sales to domestic buyers had increased sufficiently to indicate that “demand conditions remain strong.”
Friday’s personal consumption spending report – considered the Fed’s main inflation indicator – will give investors a clearer picture of where inflation is heading. If interest rates go higher, Donabedian says the Fed will have little choice but to tighten monetary policy.
“We are not far away from all interest rate cuts being reversed, contrary to investors’ expectations. “This forces Chairman Powell to adopt a hawkish tone for next week’s FOMC meeting,” he said.
Read the original article on Business Insider