Soft GDP Won't Stop Fed Inflation Fight

Even though U.S. economic growth underperformed in the advance report for the first quarter, component measures suggest a future acceleration

The headline figure for the government's advance report on first-quarter gross domestic product (GDP)—an anemic 1.3% increase, the smallest in nearly four years—provided an unpleasant surprise for financial markets on Apr. 27. An eye-catching decline in a housing-sector measure in the release added to the gloom. But a closer look at the report shows upside surprises for measures of consumption and fixed investment that offer some good news for the 2007 growth outlook.

Meanwhile, inflation gauges in the GDP report—and a separate release on Apr. 27 detailing labor costs—will keep the Federal Reserve on its toes.

Here is Action Economics' read on the reports, plus our expectation of how they may affect Fed policy:

GDP: Growth was weighed down by a big drop in residential construction, weakness in government spending, and softer trade and inventory figures that still incorporate guesses from government statisticians for the March values. It appears that the Bureau of Economic Analysis (BEA) made weaker assumptions for the March trade and inventory data than most market economists, and us, which left a much bigger drag on growth. (Jim Cooper, BusinessWeek senior editor, discusses first-quarter GDP: Watch the video)

For the GDP components, consumption posted a slightly stronger-than-expected 3.8% gain, while fixed investment outperformed our forecast with a decline of "only" 4.7%, thanks to surprisingly better-than-expected equipment and software spending. The equipment sector had sharply underperformed market forecasts in two of the prior three quarters, but posted a big overshoot in the first quarter, with a 1.9% increase instead of the assumed 3% drop. These figures have been increasingly difficult to forecast using the nondefense capital goods figures on the durable goods and factory orders reports, and the upside surprise here is certainly welcome. Government spending rose just 0.9% following the solid 3.4% gain in the fourth quarter.

The residential construction decline of 17% is attracting attention, though it actually came in above our forecast, with this upside surprise offsetting the downside surprise for nonresidential construction, which grew by only 2.2%.

Inventories subtracted a surprisingly large $7.6 billion from GDP following the $33 billion subtraction in the fourth quarter. For inventories, the undershoot of our forecast was fairly modest. Though we had assumed downside risk to the March inventory figures given the ongoing inventory correction, the only available March data are for factory inventories, which overshot our assumption, leaving what is now likely to be net upward risk for the March data.

Net exports subtracted $15 billion following the $46 billion net addition in the fourth quarter, as export growth dropped 1.2% while import growth rose 2.3%. The trade surprise was substantial, with compounding forecast errors for both exports and imports. Though we don't yet have the key source data to determine what assumptions the BEA made for March, it is clear that the BEA has a less optimistic outlook for the March data than we do. Time will tell where the net export figures end up after the next two rounds of revisions.

The real (i.e., adjusted for inflation) GDP gain was also held down by a larger-than-expected rise in a broad measure of inflation contained in the report: The chain price index posted a whopping 4.0% gain, vs. our 3.5% estimate and the 3.1% median forecast of economists. A narrower inflation gauge, the core personal consumption expenditure (PCE) chain price figure—a measure carefully watched by the Federal Reserve—actually undershot our estimate, at 2.2% vs. our 2.4% forecast. But it's the big chain price gain that will certainly capture the Fed's attention.

When the government issues its revised GDP report, it's likely that revisions will raise the first-quarter GDP gain from the lower-than-expected advance print.

In addition, we expect GDP growth in the second quarter to rebound back in the 2% to 3% range.

Employment cost index (ECI): The U.S. ECI for the first quarter modestly undershot our forecast with a 0.8% gain in the headline figure, with a surprising mix of firmness in wage growth, but a lower-than-expected reading for benefit cost growth that is good news for the ECI index.

The wage figures were as difficult as expected, with a 3.6% year-over-year gain associated with the 1.1% quarterly surge that was signaled by strength in the hourly earnings data. We face ongoing risk of strong unit labor costs increases, like the 5% gain we now expect in the first-quarter productivity report after the 6.6% surge in the fourth. Wage growth is cyclical and will remain troublesome for the Fed for the duration of the expansion.

But the small 0.1% first-quarter benefit cost gain undid what appeared to be a reversal of fortune for the benefit cost component with the hefty gains in the third and fourth quarters of 1.0% and 1.1%, respectively, and with recent strength in medical-care costs.

The Fed: The pickup in year-over-year inflation data will offset the softer-than-expected growth in the Fed's deliberations. Hence, while some in the market might be talking about a shift in the Fed's attentions from inflation toward economic weakness, we suspect that's doubtful. The Fed faces a dual mandate of maintaining price stability and fostering economic growth, and the upside risk to inflation continues notably to exceed the downside risk to the economy.

In addition, even though first-quarter GDP underperformed, the components of the report suggest a pickup in coming quarters, especially if the housing market stabilizes. We suspect this won't be lost on the Fed. While Bernanke & Co. may acknowledge the weakness in the economy at its upcoming policy meeting, it's more likely to reiterate that recent indicators have been mixed and to retain its forecast for moderate growth ahead. We also expect policymakers to say that inflation remains the predominant risk, while restating that future policy adjustments will depend on upcoming data.

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