Stubborn Inflation Joins a Downshift in Growth, Marking a Potential Risk

Article originally posted on CoStar on May 1, 2024

It didn’t take long for market optimism to fade after last week’s release of the economy’s health in the first quarter.

The Commerce Department reported that the economy expanded by 1.6% (annualized and seasonally adjusted) in the first quarter over the prior three-month period, a far cry from the 2.5% that was expected. This was a significant downshift in growth from the previous quarter, which came in at 3.4%, more than twice the rate in the first quarter and even further from the third quarter of last year when the economy grew at a blistering 4.9% rate.

In reality, economic forecasters have been expecting economic growth to slow, as the Federal Reserve has been boosting interest rates and keeping them high for more than two years. That, after all, was the goal: to cool the economy and slow job growth to keep inflation from raging. But this latest data point was still a surprise given the economy’s strong momentum coming into 2024.

The headline number may have been disappointing, but the underlying details were more optimistic. Final sales to domestic purchasers, a measure that excludes the volatile trade and inventories categories and is more reflective of fundamental economic activity, also was strong, showing growth of 2.8%. Consumer spending, the most significant contributor to economic growth and generally accounting for about two-thirds of economic activity, has been robust for the past three quarters and accounted for 1.7 percentage points of the gross domestic product’s first-quarter gain.

On this front, more detailed data on personal income and expenditures were released on Friday, showing that personal spending rose by 0.8% in March, similar to the gain seen in February, or by 0.5% adjusted for inflation, confirming the willingness of households to continue to open their wallets. However, personal income has not been keeping up, and households have begun relying on credit cards and personal loans to finance their purchases. More recently, rates on this credit have been rising and delinquencies are mounting.

The government’s report on economic growth also included other worrisome data. As measured by the core personal consumption expenditures price index, inflation rose over the quarter to 3.7%, also against expectations and faster than the headline rate of 3.4%. The combination of weaker economic growth and still-persistent inflation has sparked fears of stagflation.

The persistence of inflation comes as most forecasters expected inflation to slow further. Inflation of housing services, which had been easing, stalled in March at 5.8%, while core services excluding housing, the so-called “supercore” inflation, ticked higher, an unwelcome event. This has been the stickiest inflation component and has been slow to show a broad cooling trend.

Market watchers have been lauding a “soft landing” this year and betting on the Federal Reserve to start cutting rates soon. However, with inflation still problematic, expectations have primarily moved toward a “higher for longer” regime, with many not expecting the first interest rate cut until late 2024 and a rate hike not entirely off the table.

Risks of stagflation have yet to be apparent in the labor market. With the unemployment rate still near 50-year lows, claims for unemployment benefits languishing, and the economy adding an average of 250,000 jobs per month or more, we’re a long way from the economy stagnating. However, the April jobs report will be released this week, and we will be closely watching not only the number of positions added but also wage growth, as this is a significant impetus for inflation. The latest employment cost index, released this week, showed a quarterly rise of 1.2% in March, a sharper increase than expected and a sign that wage growth may be heating up. Watch out if this leads to price gains as businesses attempt to cover higher labor costs.