Stagflation risk grows
Cooling GDP and accelerating inflation problematic for the Fed.
Bottom line
Gross Domestic Product (GDP) surprisingly plummeted to its weakest level in nearly two years in the first quarter, falling to a much slower-than-expected 1.6% annualized growth rate. That was down sharply from much stronger gains of 3.4% in last year’s fourth quarter and a robust 4.9% increase in GDP during the third quarter. This weak first quarter marks the slowest quarterly GDP since it declined by (0.6%) in the second quarter of 2022. In the just-completed first quarter, the Atlanta Fed’s “GDPNow” estimate was for strong 2.9% growth, the Bloomberg consensus estimate was at 2.5%, the Blue-Chip consensus was estimating 2.1%, and our estimate here at Federated Hermes was for 2.2% growth.
What happened? Most of the quarterly miss was due to a significant decline in net trade because of the stronger dollar and a slower pace of inventory accumulation, both of which detracted meaningfully (1.21 percentage points) from GDP. Housing enjoyed its strongest quarter in three years, but personal consumption slowed, largely due to the weakest goods-related Christmas spending in five years, although services-related spending remained strong. Corporate spending also slowed sequentially, although gains in spending on intellectual property and equipment offset a decline in structures. Government spending slowed, but with state and local gains offsetting a decline in defense.
Private domestic final sales only slightly softer This metric gauges the economy’s underlying fundamental strength, as it excludes volatile inventory liquidation or restocking, net trade, and government spending. It rose by 3.1% in the first quarter, only slightly below the fourth quarter’s 3.3% increase and a tick stronger than the third quarter’s 3.0% gain. That suggests to us that the quality of the first quarter was not nearly as weak as the headline GDP flash might suggest, given the composition mix.
Inflation sticky and persistent The nominal Personal Consumption Expenditure (PCE) index rose by a stronger-than-expected 2.7% year-over-year (y/y) in March (consensus at 2.6%), up from a 2.5% y/y gain in both January and February. This metric had peaked at 7.1% in June 2022. Nominal PCE rose by an in-line 0.3% m/m in March, which was unchanged from February (but up sharply from zero last October and November) and which annualizes to a 3.6% increase.
The core PCE, the Federal Reserve’s preferred measure of inflation, rose by a faster-than-expected 2.8% y/y in March (consensus at 2.7%), which was unchanged from February 2024 but down by half from its February 2022 peak at 5.6% (a 39-year high). Core PCE rose by an in-line 0.3% m/m in March, which was unchanged from February (but up from 0.1% m/m gains last October and November) and which also annualizes to a 3.6% increase.
In its latest Summary of Economic Projections (SEP) in mid-March, the Fed did not change its forecast that persistent core PCE will fall to its long-run target of 2.0% by the end of 2026. In our view, the Fed recognizes that getting core inflation back to its 2.0% target will be challenging given this “stagflationary” backdrop, and it is trying to re-set overly optimistic market expectations about the prospect for future interest rate cuts. We here at Federated Hermes are now projecting perhaps one or two rate cuts this year after the election, with more in the pipeline in 2025 and 2026, depending on the trajectory of the economic data.
Details of the first-quarter GDP report:
Personal consumption (69% of GDP) rose by a softer-than-expected 2.5% q/q gain in the first quarter (accounting for 1.68 percentage points of the gain in overall GDP), weaker than the expected consensus gain of 3.0%. That compares with stronger fourth- and third-quarter gains of 3.3% and 3.1%, respectively. Spending on services rose by 4.0% q/q but goods declined by 0.4%. We could see an upward revision in this category, when we fold in strong March retail sales due to the early Easter this year.
However, we continue to expect consumer spending to slow in coming quarters. The personal savings rate declined from 4.1% in January 2024 to 3.2% in March, which helped to fuel solid Easter retail sales in March. But excess savings have plunged from a peak of $2.2 trillion in September 2021 to $40 billion in March 2024, credit card usage has slowed by half to a gain of only 8.7% over the past year, and credit card delinquencies have more than doubled to 3.1% over the past two years.
Residential construction soared by 13.9% in the first quarter, which increased GDP growth by 0.52 percentage points. That marked the third consecutive positive contribution to GDP after nine consecutive quarters of declines. That compares with gains of 2.8% in the fourth quarter and 6.7% in the third quarter. Declining mortgage rates and enormous pent-up demand resulted in a strong spring selling season. But those positive trends appear to be flattening out in the second quarter. Mortgage rates nearly tripled from 3% to 8% over the past two years, new and existing home prices spiked by 60% during 2021 and 2022 to record highs, and with negative real wage gains, housing affordability plummeted to its worst level since the mid-1980s. New incremental inventory of existing homes on the market is tepid, as homeowners are reluctant to surrender their low mortgage rates.
Corporate nonresidential capital spending rose by 2.9% in the first quarter, which added 39 basis points to overall GDP growth, versus gains of 3.7% in the fourth quarter and 1.4% in the third quarter. Structures turned marginally negative for the first time in six quarters, compared with solid gains of 10.9% in the fourth. quarter, 11.2% in the third quarter, 16.1% in the second quarter and 30.3% in the first quarter. Equipment spending rebounded by 2.1% in the first quarter (adding 10 basis points to overall GDP), versus declines of 1.1% in the fourth quarter and 4.4% in the third quarter. Once again, intellectual property was the star of the capex category, as spending grew by 5.4% for the thirteenth consecutive quarter (adding 29 basis points to GDP growth), compared with a 4.3% fourth-quarter gain.
Government spending rose for the seventh consecutive quarter by a modest 1.2% q/q in the first quarter, adding 0.21 percentage points to overall GDP, compared with a 4.6% fourth-quarter increase and a 5.8% third-quarter gain. Federal spending declined by 0.2% in the first quarter, largely due to a 0.6% decline in defense spending. But state and local spending rose by 2.0% in the first quarter adding 22 basis points.
Inventories rose by $35.4 billion in the first quarter, but that pace was nearly 36% slower than the $54.9 billion inventory build in the fourth quarter. That slower pace subtracted 0.35 percentage points from overall GDP growth. Inventories had risen to $77.8 billion in the third quarter to prepare for the United Auto Workers strike. But with that behind us, this anticipated inventory liquidation is reducing GDP growth.
Net trade declined by $973.2 billion in the first quarter, subtracting 0.86 percentage points from overall GDP growth. In the fourth quarter, net exports had declined by only $918.5 billion, which added 0.25 percentage points to fourth-quarter GDP. Due to relative first-quarter strength in the dollar against the yen, pound, and euro, which makes U.S. exports less attractive, exports rose by only 0.9% q/q in the first quarter, which added 10 basis points to GDP, compared with growth of 5.1% in the fourth quarter and 5.4% in the third quarter. But imports surged by 7.2% q/q in the first quarter, which subtracted 0.96 percentage points from GDP growth, compared with smaller gains of 2.2% in the fourth quarter and 4.2% in the third quarter.