The Big Idea
Real GDP growth cooling
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Real economic growth surged in the second half of last year, averaging close to 4% due to solid consumer spending, a rebound in housing activity and robust gains in government outlays. The economy got out of the gates well this year, but the underlying trend in activity appears to be moderating, which, in my view, is a necessary condition for bringing inflation back down toward the Fed’s 2% target.
Red-hot economy
Real GDP growth surged in the second half of last year, advancing at a 4.9% annualized pace in the third quarter and a 3.4% pace in the fourth quarter, an average of almost 4% for the combined period. Real domestic demand, which excludes the volatile inventories and net exports components of GDP, posted rises of 3.5% in the third quarter and 3.6% in the fourth quarter.
In several recent pieces, I explored some of the key sources of this strength, highlighting government spending a few weeks ago and, more recently, the consumer.
The other noteworthy development last year was a bounce back in the housing sector. Real activity in residential construction rebounded violently after the lockdowns in 2020, reaching an unsustainably high level by early 2021 at nearly 20% above pre-pandemic levels. From there, the sector posted nine consecutive quarterly declines through the spring of 2023, as rising mortgage rates in 2022 dampened demand for homes. However, as mortgage rates broadly leveled off last year, once the FOMC stopped hiking its policy rates, real housing activity turned around in the second half of 2023, posting modest annualized increases. As a result, the sector went from a modest drag in the first half of the year to a small plus in the second half, a swing of about three tenths of a percentage point with regard to real GDP growth.
A turn to moderation
Though the economic data, especially payrolls and inflation, firmed dramatically in early 2024, the GDP figures show a degree of moderation. The preliminary real GDP print for the first quarter of 1.6% annualized is deceptive, in that it includes notable drags from both inventories and net exports. Real domestic demand posted a 2.8% annualized increase in the first quarter, still solid but down somewhat from the torrid performance in the two prior quarters. Moreover, revisions to retail sales and other relevant inputs to GDP suggest that real domestic demand in the first quarter may be adjusted lower, perhaps to a gain of about 2.2%.
The current quarter may register a similar increase. At the moment, I look for solid growth in consumer spending and modest rises for housing, business fixed investment, and the public sector to generate an advance of around 2.5% in real domestic demand in the second quarter.
This would suggest a deceleration in real domestic demand of just over a full percentage point from the second half of last year to the first half of this year. Still, my projections work out to an average increase of 2.4%, noticeably above most estimates of the economy’s long-run potential growth; the FOMC pegs long-run potential at 1.8%. Consequently, in the first half of the year, it would be fair to say that an economy performing in line with my expectations would still be running hot.
Losing steam
I have made the case in recent pieces that the economy is likely to slow over the course of the year as the momentum in both consumer demand and government outlays wanes. My current forecasts for the second half of the year show a substantial further cooling in the economy. Real government spending, which surged at a more than 5% annualized pace in the second half of last year, may rise by just over 1% later this year. Meanwhile, real consumer spending may follow the 2.7% rise seen in the four quarters of 2023 and an average gain of over 2% in the first half by cooling to around a 1% average advance in the second half of the year, as income growth slows and the cumulative burden of high inflation and interest rates continues to build.
As a result, I currently project that real domestic demand in the second half of the year may increase by just over 1% annualized. In my view, this is a necessary condition for bringing inflation lower. Chair Powell and the FOMC for much of 2022 and 2023 took the view that the economy would need a period of below-trend growth and some loosening in the labor market for inflation to return sustainably to the 2% target.
The combination of strong growth and falling inflation in late 2023 seems to have entranced policymakers, with Powell suggesting in January and in March, that the Fed might have its cake and eat it too. That is, he asserted that the Fed might be able to guide inflation back to 2% while the economy remained robust and the labor market stabilized at a full employment level. I view the FOMC’s economic outlook as overly optimistic. We do not necessarily need to endure a recession to bring inflation down, but I do believe that a period of below-potential growth is needed, so that the labor market and the economy more broadly can be brought off the boil after overheating in the wake of the pandemic.
Monetary policy path
Having gotten too upbeat about inflation already at the beginning of this year and having their hopes dashed by the reacceleration in prices in recent months, Fed officials are likely to be more conservative about declaring progress on the inflation front next time. Going forward, policymakers will probably watch not only for declines in the aggregate but also for a broader moderation in inflation, in contrast to the narrowly based progress seen last year. Focusing on alternative measures of inflation like median and trimmed mean calculations allowed me to conclude that last year’s rapid declines in core inflation were unlikely to be sustained into 2024.
As Powell and others at the Fed have noted, the difficulty at present is that core services inflation has been stubbornly high. For most services businesses, labor is the most important input and thus the biggest input cost. It is also the case that many services firms tend to change their prices less frequently. As a result, the lagged impact of sharp cost increases (most importantly for labor) that occurred when the economy was significantly overheated in 2022 and 2023 are still likely flowing through to prices. The passage of time will undoubtedly help bring services inflation down, but to ultimately return to 2% underlying inflation, I believe that the labor market will need to cool somewhat, a development that would likely follow from the slowdown in economic growth that I am projecting.
I still believe that the Fed will cut rates this year by 50 bp, beginning in November, but this call hinges on the economy cooling noticeably over the next six months or so. Otherwise, inflation is unlikely to decelerate enough to generate “greater confidence” on the FOMC.
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