KEY DATA: GDP: +0.5%; Consumption: +1.9%; Income: +2.9%; Core Consumer Inflation: +2.1%/ Claims: +9,000
IN A NUTSHELL: “The economy eked out a gain in the first quarter but with incomes rising solidly, we should see better growth in the quarters to come.”
WHAT IT MEANS: Phew! We dodged the negative bullet. Whoopee! Okay, a growth rate of less than one percent is not something to be happy about and no one is. But let’s discuss the details first to determine if this is a turning point that leads to better growth or a report that warns a recession is coming. Consider consumer spending, which was okay, at best. The big problem was durable goods, which was basically flat. A “weaker” than normal March vehicle sales number was the reason. On the other hand, services demand, which I see as a true indicator of consumer attitudes, remains strong. Looking forward, incomes, especially wages and salaries, are growing at a pace that should fund solid, if not strong consumption. That could happen even if the savings rate continues to filter upward. On the investment side, it was largely the energy complex cutbacks that kept investment down. Residential construction was a major positive for the economy, though that may add less going forward. One other factor points to a better growth rate ahead: The inventory adjustment process, which has restrained growth for the three quarters, looks to be largely over. The inventory build was more “normal”, even if it did subtract one-third percentage point from growth. The trade deficit widened, not surprisingly, as the world economic problems and the strong dollar led to a decline in exports. Imports were largely flat. Finally, sequestration is doing its job and federal spending for defense items was down. Looking at inflation, the top line consumer inflation rate rose minimally. Excluding food and energy, it increased at a 2.1% pace in the first quarter, just above the Fed’s target, and by 1.7% over the year. If oil remains in the $45 per barrel range, the huge year-over-year declines we have seen in energy costs will disappear by fall. That would move the top line number close to the Fed’s target as well.
Jobless claims rose last week. Since the previous week’s level was the lowest on record, when adjusted for the labor force, that was hardly an issue. The labor market is tightening further and that bodes well for income growth, which we saw in the first quarter was already strong.
MARKETS AND FED POLICY IMPLICATIONS: The economy essentially stalled in the first quarter, but that doesn’t mean it is faltering. If oil prices stabilize near where they are currently, or even rise modestly, the massive cutbacks in the energy sector would dissipate. Households have the income to spend and they are likely to do that. With the dollar retracing some its rise, the negative effects on exports should ease as well. For all these reasons, growth is likely to accelerate going forward. Of course, Janet Yellen wants to see it before she will believe it, and yesterday’s FOMC statement made it clear that weak growth is a major factor in the Fed’s thinking. But for me, the issue is inflation. Right now, it is so low, at least on the headline number that the Fed has all the freedom it needs to keep rates at current levels. But wage gains are accelerating and with productivity gains largely nonexistent (and probably negative in the first quarter), businesses may need to recoup their rising labor costs by raising prices. It would not take much for the inflation rate to go above the Fed’s target of 2% if the energy price restraint disappears and business increase prices even modestly faster than they have. This report is why the Fed signaled a June rate hike is likely off the table. But it also contains enough information to suggest that a rate hike this summer remains a possibility.