GDP slower, inflation higher + ISM indices still point to growth and inflation
-- David M Gordon / The Deipnosophist
The bond market was excited last week by news that economic growth in the second quarter dipped to 2.5%, below expectations, since this bolsters the case for the Fed to take a long-awaited breather next month from its 2-year tightening campaign. However, as the charts show, weaker growth has come at the expense of higher inflation. Nominal GDP today is growing at just about the strongest pace we have seen since 1990, while real growth, at 3.5% over the past year, is substantially below the 4-5% growth rates we saw in the late 1990s. The Fed will undoubtedly be comforted to see a slower pace of growth, but they will also remain worried that inflation is drifting higher. If these trends continue much longer, it will put the Fed squarely on the horns of a dilemma: whether to ease in deference to the economy or tighten in reaction to uncomfortably high inflation.
Both the Fed and the bond market believe that slower growth will bring lower inflation in the future, although just the opposite has been the case over the past decade. TIPS breakeven spreads are forecasting the CPI to rise at a 2.2 % rate for the remainder of this year, and only 2.6 % over the next 18 months, both down sharply from the 4.3% pace of the past year.
The Institute for Supply Management's index of manufacturing activity was a bit stronger than expected today, and at 54.7 is still consistent with economic growth in the neighborhood of 3-4%. The ISM price index remains in distinctly elevated territory, at 78.5, and as the second chart suggests, rising energy prices help explain why.
The core PCE deflator for June was released today, and with revisions to past data we now see that inflation by the Fed's preferred measure has been above its 1-2% target range for the past two years. Over the past year the core PCE deflator is up 2.4%, and in the past six months it has risen at a 2.7% rate. It would thus appear that monetary policy has been somewhat accommodative, since higher energy prices are finding their way into non-energy prices.