How the Fed Should Fight Inflation
Economic data for the coming week is expected to show a slump in economic growth and a surge in inflation in the first quarter. While the second quarter numbers will likely partially offset these two trends, they will remind investors of the challenges facing the Federal Reserve in trying to get the economy back on a path of steady growth and subdued inflation. While some Fed officials have advocated very aggressive tightening, the likelihood of near-term moderation in growth and inflation and longer-term disinflationary forces suggest that it would be wiser for the Fed to tighten. take a slow and steady approach to fighting inflation.
On the growth side, the main release this week will be the first quarter real GDP, which is due out on Thursday. We currently expect a sharp deceleration to 0% growth from a 6.9% gain last quarter. It should be noted that this likely exaggerates any underlying deceleration in the US economy and primarily reflects very large swings in stocks and trade.
Looking at demand-side GDP, we estimate a very solid 4.7% gain in real consumer spending in the first quarter, driven primarily by gains in leisure, entertainment and travel as the effects of the pandemic are fading and some increase in light vehicle sales from supply-limited levels in the fourth quarter. We estimate that fixed investment spending grew by even more than 13.2% annualized as companies benefited from low interest rates and strong earnings gains. Capital expenditure gains should have been very large, covering equipment, construction and R&D.
However, government spending appears to have lagged, growing at less than 1.0% annualized. Federal, state and local government employment rose a modest 46,000 or 0.8% annualized in the first quarter and is still down more than 700,000 from pre-pandemic levels. It may be that, in an economy that is chronically understaffed, the government sector simply does not have the compensation flexibility to fill vacancies. Similar issues may have impacted public construction, which in January and February was essentially unchanged from the fourth quarter in nominal terms and down when adjusted for inflation.
More importantly, inventories and trade were likely major drags on first-quarter GDP.
According to the Bureau of Economic Analysis, actual inventories rose at a record $193.2 billion in the fourth quarter, converting a modest 1.4% gain in actual final sales into a 6.9% increase. of real GDP. Annual revisions, scheduled for the end of July, could well reduce this estimate. However, for now, the fourth quarter estimate remains in place and any reduction in actual inventory accumulation will hurt first quarter economic growth.
Such a reduction seems quite likely based on both a slower pace of nominal inventory accumulation in January and February and significantly higher wholesale inflation. March reports on durable goods and wholesale and retail inventories, due tomorrow and Wednesday respectively, should allow economists to tighten their estimates of first-quarter inventories. However, for now, we estimate only $90 billion of real inventory accumulation in the first quarter, which subtracts more than 2 percentage points from real GDP growth.
International trade is also expected to be a big negative in the GDP report, reflecting both strength in US consumer demand and some of the impact of the rising US dollar. In January and February combined, nominal imports of goods and services rose 19% at an annualized rate from the fourth quarter, while exports rose only 1%. Moreover, export prices rose faster than import prices in the first quarter, implying a greater deterioration in actual trade figures than nominal ones. Data due Wednesday showing flash estimates of March merchandise trade should allow for more accurate estimates. However, based on what we know now, it looks like the actual trade deficit has fallen from a record $1.35 trillion annualized in the fourth quarter to a new record high of $1.48 trillion in the fourth, which represents an additional loss of 2.5 percentage points in relation to GDP growth.
Summing up the components of demand, this suggests 0% real GDP growth in the first quarter, which may well raise further concerns about stagflation.
It should also be noted that these numbers will undercut pandemic-era productivity gains. A little silver lining in the very dark cloud of the pandemic recession is that productivity seemed to increase significantly, likely due to the adoption of more efficient online shopping or the use of remote communications instead of physical meetings. . In 2020 and 2021 combined, hourly output in the non-farm business sector grew at an annualized 2.3%, more than double the 1.0% annualized pace achieved in the previous 10 years.