Recent Economic Data Confirm the Economy Continues to Cool, with Inflation Remaining Elevated Relative to Target
This week, all eyes were trained on the advance estimate of Real GDP for the first quarter of 2024. Market expectations were for growth to slow from the fourth quarter of 2023 pace of 3.4% to a more normal 2.5% rate. But growth came in at a pace much below even pessimistic forecasts at 1.6%, a marked deceleration in the rate of growth. The advance estimate is often revised, and we would expect it to be given the degree to which it underperformed expectations. Nonetheless, you go with the data you have, not the data you wish you had, to form your view on the health of the economy.
Growth is a mean-reverting thing: too high, and it will inevitably correct to the downside; too low, and it will rally. Oscillations in growth have become less severe in the last century as Central Banks have improved data collection, systematized their reactions to economic conditions, and more carefully calibrated the impacts of their policy changes. Milton Friedman once famously compared Central Bankers to a "Fool in the Shower" who is doomed to be scalded and frozen because he over- and under-reacts to changes in water temperature with zealous adjustments to the faucet. The comparison seems inept today since we understand much better the limits of data and predictive statistics, and the irreducible difficulty of navigating complex adaptive systems.
It is evident from the direction of travel if not the level of growth that the Fed's interest rate policy continues to bite. Short rates of 5.25 - 5.5%, and yields of 4.5 - 4.7% have effectively restrained the rate of economic expansion, and may well arrest it altogether.
We also received critical inflation measures this week, which essentially confirmed what we already know: inflation is elevated, higher than target, but not threatening to break out. The GDP Price Deflator is an especially broad measure of inflation, as it takes into account the change in prices of things people actually buy, so it captures substitution effects in a way that the basket-of-goods methods fail to: the Bureau of Labor Statistics' Consumer Price Index (CPI), for instance, tells us about the change in price of a pound of butter, but if the price of butter and a substitute like margarine suddenly diverge and consumers respond by buying more margarine than butter, the CPI will fail to register this effective fall in the general price level. While the GDP Implicit Price Deflator and CPI travel in the same direction over time, over short periods of time they can differ in terms of level. We had written earlier that inflation, while elevated, remained at reasonable levels and continues to moderate, and the GDP Price Deflator demonstrates this trend. It was up in Q1, as expected, but still lower than recent upswings.
The Fed prefers the Personal Consumption Expenditures (PCE) Price Index as a higher-frequency measure of inflation to the CPI as, like the GDP Deflator, it is based on what people actually buy, and have bought for them. The PCE also rose on a year-over-year basis, but came in at 2.7%, lower than CPI.
The Core PCE Price Index, which excludes food and energy prices, also showed declines in prices, although its pace of decline has moderated. Core price increases have proven resilient as the easier gains from goods prices inflation have now all been realized, and stickier services prices inflation are robust. The effects of the negative supply shock from COVID have left the data, and what now remains are those price pressures that every economy in the late stages of the business cycle face. The tradeoff between growth and inflation will become increasingly acute.
Further removing the impact of shelter, Supercore inflation (inflation excluding food, energy and shelter) showed a very slight increase, essentially signifying that we've found the floor on core inflation.
Turning from GDP and Inflation to other indicators, we see other indicators that growth is slowing. The Personal Savings Rate has fallen to 3.2%, an early sign that consumption is likely to contract.
When savings decline, consumers turn to personal credit to finance expenditures. We've seen credit balances increase of late, only to pull back slightly. Higher interest rates are likely to deter usage of consumer credit, and we expect to see consumers use their tax returns to extinguish credit rather than consume.
These signs are all indicative of late-cycle dynamics where growth is positive but falling, inflation is elevated, the labor market is tight, savings are deteriorating, and credit is contracting. The strong signals we've received from the labor market this past quarter belie these signs, causing us to question which of these two divergent currents will ultimately prevail. It is possible that a strong labor market continues to support demand and that will be sufficient to keep the economy from slipping into recession. But we have seen the impact that a fall in consumption can have, as when Retail Sales fell off a cliff in January. It has since recovered but fell again slightly this past month.
So, growth should likely continue to decelerate as the economy contends with high real interest rates. Inflation will continue to drift down, though incrementally and in fits and starts. This year's increase due to a hike in auto insurance premiums won't be repeated, and the price of shelter is due to relax as large amounts of new supply comes on line this year, further depressing prices. With the easy-to-tame inflation now tamed due to the easing of supply pressures, the harder-to-tame inflation is now the Fed's focus. This inflation is due to demand pressures, which are picking up globally and still robust in the United States. Higher interest rates are now working on these pressures and are pinching. Whether they are pinching enough to bring them to heel will bear watching over the next quarter.