Hotter-than-expected first quarter growth is likely to revive the debate within the Federal Reserve about the direction of policy, but Fed officials are likely to be content to stay on the sidelines for now, particularly with inflation so low.
The economy grew at a surprising rate of 3.2% in the first quarter, well above the consensus forecast of 2.5%. Also reported Friday was the latest PCE inflation data for the first quarter, showing core inflation at 1.7% year-over-year, down from 1.9% in the fourth quarter. Personal consumption expenditures [PCE] data for February and March are released Monday and should also show a weaker inflation trend.
The Fed meets for two days next week, followed by an afternoon briefing Wednesday by Fed Chairman Jerome Powell. The Fed is not expected to take any action on interest rates, but it is expected to upgrade its view of the economy and Powell may comment on inflation when he briefs the press. The Fed last raised interest rates in December.
“It’s going to be tough for them to start their engine. It’s partly economics. It’s partly low inflation. The puzzle is why strong growth doesn’t lead to more inflation.That’s part of it. The other part of it is the political winds are very unfavorable to rate hikes right now,” said Chris Rupkey, chief financial economist at MUFG.
President Donald Trump, who has been critical of the Fed and wants it to cut interest rates, commented on the stronger GDP growth in a tweet Friday morning. He also made a point of saying that inflation was very low.
At its March meeting, the Fed eliminated interest rate hikes from its outlook for this year, and while it is on hold, some in the markets expect the central bank’s next move to be a rate cut.
“The Fed can rest easy here…the second key data in the report today is the PCE deflator is down and moving lower. Core inflation pressures, despite 3% growth, are going nowhere. Data that’s going to come out Monday is going to show inflation stuck in a rut, and there’s no need for the Fed to re-engage,” said Rupkey. The Fed has targeted 2% inflation, but some Fed watchers say it may discuss next week keeping 2% as an average target, allowing inflation to run both above and below it.
Treasury yields initially jumped on the GDP report, as investors sold, but the fact that inflation looked weaker and the fact transitory factors of inventories and trade boosted growth dampened some of the enthusiasm. Bonds quickly reversed and prices were bid higher. Yields, which move opposite price, moved lower with the 2-year touching 2.26%.
“The inventory accumulation and net exports contributed almost 1.7. Those are swing factors. That’s not going to be repeated in Q2. My guess is it either detracts a little or makes no contribution [in Q2],” said Ward McCarthy, chief financial economist at Jefferies. Economists say inventory buildups can be followed by periods of drawdown, and that could have a dampening affect on growth.
But economists said the consumer is strengthening, evident in the 1.6% jump in retail sales in March, and that should carry through and push GDP higher in the second quarter though not at the pace of first quarter. The first quarter defied early forecasts of near flat growth, based on drags on early winter data from the government shutdown and bad winter weather.
“So much for the perpetual pessimism. You’ve got a contribution from a lot of things. The consumer only contributed 0.8 to growth and the consumer spending is on the upswing headed into q2, so that’s a good thing,” said McCarthy.
As for the Fed, some market pros have been concerned about what Powell might say, since the Fed’s surprisingly dovish stance in both January and March helped fire up an equities rally that took both the S&P 500 and Nasdaq to new highs. Stocks were lower Friday, after both ExxonMobil and Intel released disappointing earnings reports.
“They’re in patient mode. I’m sure at least a lot of them are surprised. The perpetual pessimism was a contributor to the 180 degree pivot they did,” said McCarthy. “I’m sure it’s going to heat up the internal debate on what the direction of policy should be.”
Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch, said there is a risk the market is expected too much dovishness from the Fed chairman.
“I don’t think the Fed is going to signal any big change in policy stance next week. If anything, they will talk about how the economy is showing signs of improvement and therefore, it is appropriate to remain patient and see how things evolve,” said Cabana.
Rupkey said the economy is on track for growth above 2% for the rest of the year, after investors fretted a recession could be on the horizon and some bond market pros are positioned for lower growth. The talk in the bond market this week was about the lack of inflation, and therefore no reasons for the Fed to sound any more hawkish.
“It’s open to interpretation, depending on whether your glass is half full or half empty. it’s a shock it’s 3% at the end of the day. I don’t care how many moving parts there are. It’s not down in the dumps. it’s not a recession. Were’ at 3%…Nothing but nothing got the economy down,” said Rupkey.