Economic growth and inflation both higher than expected
Combination could chill the Fed longer than the consensus believes.
Published July 26 2024
Bottom line
This week’s flash reports on second quarter Gross Domestic Product (GDP) and June’s core Personal Consumption Expenditures (PCE) index were respectively stronger and stickier than expected, which may alter the growing consensus narrative that the Federal Reserve is on the verge of beginning to cut interest rates next week or in September.
Gross Domestic Product (GDP) surprisingly surged to a much stronger-than-expected 2.8% annualized growth rate in the second quarter, which was double the first quarter’s tepid pace of only 1.4% growth. The Atlanta Fed raised its “GDPNow” estimate from 1.5% in early July to 2.7% last week; the Bloomberg consensus estimate was at 2.0%; the Blue-Chip consensus was estimating 1.8%; and our estimate here at Federated Hermes was for 2.0% growth.
What drove the stronger quarter? Personal consumption was better than expected, rising by 2.3% in the second quarter (consensus growth at 2.0%), which added 1.57 percentage points to the overall GDP print, compared with only 1.5% first-quarter growth. Corporate spending also rose by a solid 5.2%, largely due to strong spending on equipment, adding 0.69 percentage points to GDP. Government spending rose by 3.1%, thanks to a surge in national defense spending, adding 0.53 percentage points to GDP growth. Finally, inventory accumulation soared by $71.3 billion in the second quarter, which added 0.82 percentage points to overall GDP.
On the negative side of the ledger, housing declined for the first time in a year, falling by 1.4% and reducing GDP by a modest five basis points. Because of the relative strength of the dollar and the U.S. economy compared with our major trading partners, imports grew at a much more robust 6.9% versus export growth of 2.0%, so net trade reduced GDP by 0.72 percentage points.
Private domestic final sales flat 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 2.6% in the second quarter, which was unchanged from the first quarter and moderately slower than the fourth quarter’s 3.3% increase. That suggests second quarter growth was not as strong as the headline GDP flash suggests, due to unsustainably strong inventory accumulation and government defense spending.
Inflation remains sticky The core PCE (the Federal Reserve’s preferred measure of inflation) rose by a firmer-than-expected 2.6% y/y in June (consensus at 2.5%), which was unchanged from May 2024 but down by 3.0% from its February 2022 peak at 5.6% (a 39-year high). Core PCE rose by an in-line 0.2% m/m in June, which was double May’s 0.1% m/m gain.
In its latest Summary of Economic Projections (SEP) in mid-June, the Fed did not change its forecast that core PCE will gradually decline to its long-run target of 2.0% by the end of 2026. But the Fed did increase its forecast for core PCE this year from 2.6% to 2.8%, which implies an inflationary spike in this year’s second half. That’s consistent with the strong uptick we’ve seen in wholesale inflation in recent months, as the core Producer Price Index (PPI) has surged from 1.8% y/y in December 2023 to 3.0% in June 2024. Perhaps the Fed recognizes that wholesale inflation could creep into retail inflation over time.
So, given this week’s much stronger-than-expected economic growth and stickier-than-expected inflation, might the consensus be overly optimistic that the Fed is on the cusp of imminently cutting interest rates? We are also amid the most contentious presidential election in history, and the Fed typically prefers not to put its proverbial thumb on the election scale if its monetary policy decision is splitting hairs. Consequently, we here at Federated Hermes are projecting one or two rate cuts this year after the election, with more in the pipeline in 2025 and beyond.
Here are the details in the second-quarter GDP report:
Personal consumption (which accounts for 69% of GDP) rose by a stronger-than-expected 2.3% q/q in the second quarter (contributing 1.57 percentage points to the gain in overall GDP), higher than the expected consensus increase of 2.0%. That compares with a weaker first-quarter gain of 1.5% but is below the fourth quarter’s increase of 3.3%.
Second quarter personal consumption was salvaged by a surprisingly stronger-than-expected surge in control retail sales for June, which soared by 0.9% m/m. We also expect retail sales in July to be strong, but we continue to expect consumer spending to slow in coming quarters. The personal savings rate declined from 5.3% in May 2023 to 3.4% in June 2024, which has fueled spending recently but is unsustainable. Excess pandemic personal savings have plunged from a peak of $2.2 trillion in September 2021 to a negative $250 billion in June 2024, credit card usage has slowed sharply to a gain of only 7.3% at mid-year, and credit card delinquencies have more than doubled to 3.2% over the past three years.
Corporate nonresidential capital spending rose by 5.2% in the second quarter (which added 69 basis points to overall GDP growth), versus gains of 4.4% in the first quarter, 3.7% in the fourth quarter of 2023 and 1.4% in the third quarter. Structures were negative for the first time in seven quarters, declining by 3.3% in the second quarter, compared with gains of 3.4% in the first quarter, 10.9% in the fourth quarter of 2023, 11.2% in the third quarter, 16.1% in the second quarter, and 30.3% in the first quarter. Equipment spending soared at its fastest pace since the beginning of 2022, surging by 11.6% in the second quarter (adding 55 basis points to overall GDP), versus a gain of 1.6% in the first quarter and loses of (1.1%) in the fourth quarter of 2023 and (4.4%) in the third quarter. Intellectual property grew by a steady 4.5% in the second quarter for the fourteenth consecutive quarter, compared with gains of 7.7% in the first quarter and 4.3% in the fourth quarter of 2023.
Government spending rose for the eighth consecutive quarter (after five consecutive negative quarters) by 3.1% q/q in the second quarter, versus increases of 1.8% in the first quarter, 4.6% in the fourth quarter of 2023 and 5.8% in the third quarter. Federal spending rose by 3.9% q/q in the second quarter, largely due to a 5.2% surge in defense spending, which added 19 basis points to overall GDP growth. State and local spending rose by 2.6% in the second quarter (adding 28 basis points to GDP growth).
Inventories soared by $71.3 billion in the second quarter, nearly triple the first quarter’s $28.6 billion inventory build. That much-faster pace added 0.82 percentage points to overall GDP growth. Inventories had risen by $77.8 billion in the third quarter of 2023 to prepare for the UAW strike, but that elevated pace is unsustainable, which suggests that anticipated future inventory liquidation will reduce GDP growth.
Residential construction slipped for the first time in a year, declining by a modest 1.4% in the second quarter, which reduced overall GDP growth by 5 basis points. That compares with solid gains of 16.0% in the first quarter, 2.8% in the fourth quarter of 2023 and 6.7% in the third quarter. Prior to that, housing had declined for nine consecutive quarters. Mortgage rates have nearly tripled from 3% to 8% over the past two years, new and existing home prices spiked by 60% to record highs, and with negative real wage gains, housing affordability plummeted to its worst level since the mid-1980’s. Existing homeowners are reluctant to surrender their low mortgage rates, so inventory levels are low.
Net trade declined by $1.007 trillion in the second quarter, subtracting 0.72 percentage points from overall GDP growth, compared with net export declines of $960.3 billion in the first quarter and $918.5 billion in the fourth quarter of 2023. Due to the relative second-quarter strength in the dollar against the yen, pound, and euro (which make our exports less attractive) and the relative strength in the U.S. economy (which fuels our ability to purchase foreign goods), exports rose by only 2.0% q/q in the second quarter (which added 22 basis points to GDP), compared with growth of 1.6% in the first quarter, 5.1% in the fourth quarter of 2023 and 5.4% in the third quarter. But imports soared by 6.9% q/q in the second quarter (which subtracted 0.93 percentage points from GDP growth), compared with smaller gains of 6.1% in the first quarter, 2.2% in the fourth quarter of 2023 and 4.2% in the third quarter.