Economists were left reeling on Thursday after new data showed evidence of persistent inflation and a slowdown in US growth. Real gross domestic product (GDP) rose just 1.6% in the first quarter from a year ago, the Bureau of Economic Analysis reported Thursday. . That was well below economists’ consensus forecast for 2.5% growth, and a significant decline from 3.4% growth in the fourth quarter of last year.
Meanwhile, the Federal Reserve’s favorite inflation gauge – the main price index for personal consumption expenditures (PCE), which excludes more volatile food and energy prices – rose from 2% in the fourth quarter of 2023 to 3.7% in the first three months this year, easily exceeding the 2.1% inflation forecast by the Survey of Professional Forecasters in February.
“This was the worst of both worlds report: slower than expected growth, higher than expected inflation,” said David Donabedian, chief investment officer of CIBC Private Wealth US. Fortune via email.
Donabedian argued that the “biggest setback” was the spike in core inflation, especially in the services sector, where consumer price growth is above 5% annually. For Fed Chairman Jerome Powell and his fellow central bankers, who were hoping inflation would ease so they could cut rates and boost the economy, this new data means tough times ahead. “We are not far away from seeing any rate cuts fall outside of investor expectations,” Donabedian said. “It forces Chairman Powell to take an aggressive tone for next week’s FOMC meeting.”
Citi economists, led by Veronica Clark, echoed that sentiment in a Thursday note, arguing that the Fed’s favorite inflation gauge is likely to rise to 2.8% when the March numbers are revealed Friday, prompting officials at the central bank will be forced into a more aggressive position. As a result, Clark and her team now expect the first rate cut in July, rather than June. “But we still think the markets are wrong to fully price out the cuts this year,” she wrote.
As fiscal stimulus support fades and spending on goods weakens, concerns about economic growth will ultimately weigh on the Fed’s decision to cut or keep interest rates high. “We still think Fed cuts will come this summer before inflation has slowed sustainably,” Clark said.
However, investors on Thursday were clearly focused on evidence of persistent inflation in the first-quarter GDP report and seemed less enthusiastic about the chances of rate cuts that would undermine the market next summer. The Dow Jones Industrial Average fell 1.5% Thursday afternoon as investors digested the first-quarter GDP report, while the S&P 500 fell 1.1% and the tech-heavy Nasdaq Composite tumbled 1.5%.
After many leading Wall Street forecasters and economists recently adopted a new outlook for the U.S. economy — a “no landing” scenario with more robust economic growth and slightly higher inflation — EY chief economist Gregory Daco argued that the GDP report on the first quarter also negated that theory. . “This report pours cold water on the misleading stories about a re-accelerating economy,” he said Fortune via email.
Daco said he believes economic growth will continue to cool in the second quarter due to “stubborn inflation,” tight credit conditions and weaker labor demand. “And we emphasize that if inflation proves to be more persistent than expected, the downside risk to the economy from reduced real income growth, a ‘higher for longer’ stance from the Fed and tightening financial conditions could be notable,” he said.
David Russell, global head of market strategy at TradeStation, even argued that the US economy could be facing an economic nightmare scenario that has been playing out since the 1970s.
“Stagflation is a growing risk after GDP missed and the price index surprised on the upside,” he said Fortune via email. “If inflation doesn’t improve with such weak growth, you have to wonder whether the trend toward lower prices will continue.” That theory was supported by JPMorgan Chase CEO Jamie Dimon, who told The Wall Street Journal This week has shown that stagflation is a risk the Fed cannot ignore.
A word of caution on the weak GDP data
While the first quarter GDP report was undeniably concerning, there were some caveats surrounding the weak growth metrics. First, private domestic demand, a measure of real final domestic sales, actually rose 3.1% in the first quarter. “The 3.1% growth in real private domestic investment is encouraging as it tends to be a strong leading indicator of future near-term GDP growth,” William Bair analyst Richard de Chazal said in a note on Thursday.
Spending on health care, financial services, insurance and other services also continued to rise in the first few months of this year, even as goods spending slowed, suggesting underlying demand remains robust.
Paul Ashworth, chief economist at Capital Economics, explained in a note on Thursday that rising US imports compared to exports also significantly reduced GDP growth in the first quarter, masking signs of underlying economic momentum.
“Exports ultimately rose by just 0.9%, illustrating the impact of weak global demand, while imports rose by 7.2%,” he explains. “In total, net exports subtracted almost 0.9 percentage points from GDP growth, while inventories generated an additional drag of almost 0.4 percentage points.”
These caveats mean that there was likely more underlying strength in the economy than the first quarter GDP growth figures indicated. That’s a good sign for consumers and businesses, but it will also keep the Fed from cutting rates — at least “for now when demand is generally okay but inflation is still uncomfortably high,” according to William’s De Chazal Blair.