US Growth, Inflation and the Federal Reserve

by George Hatjoullis

US real GDP it seems grew by an annual rate of only 0.2% in Q1 2015. This looks like a dramatic slowdown when compared to the Q4 2014 annualised growth of 2.2%. On the other hand it looks pretty good compared to Q1 2014 when real GDP fell by an annualised 2.1%. The Federal Reserve evidently thinks Q1 2015 real GDP growth is an aberration as the FOMC statement for April states:

The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate.

It is still going to raise interest rates some time in the not too distant future because of the lags in monetary policy and the Committee’s confidence that inflation is heading back to 2% in the ‘medium term’. The Q1 2015  result could well be temporary. It certainly was in 2014 and both quarters have been affected by severe weather. It may even be taken as a sign of underlying strength in the US economy that on this occasion the temporary factors did not result in a more serious slowdown. A closer look at the data ( reveals reasons to be concerned, at least about the path of inflation.

A significant part of the real GDP growth slowdown appears related to real net exports and non-residential fixed investment. It is not obvious why either should be viewed as temporary. The US Dollar has strengthened substantially and one would expect some adverse response from real net exports. It may not reverse until the US Dollar strength reverses. This is unlikely if the market expects the Federal Reserve to raise interest rates faster that it deems necessary. Investment is hardly going to be boosted in a rising interest rate environment, so why exactly should it pick up? Sluggish investment is a function of a generalised aversion to risky assets (which i have discussed at length in previous blogs) and the collapse in oil prices. The latter is seen as ‘temporary’ but this is not self evident. It could last a long time and may indeed be part of a secular drift away from expensive and environmentally questionable fossil fuels.

The oil price also figures prominently in the inflation optimism of the Fed. The decline will cease, maybe reverse a little, and allow other underlying inflation pressures assert themselves. According to Appendix Table A in the above link the GDP price deflator fell 0.1% in Q1 2015. If one excludes food and energy it rose 0.4%. So does the Fed have a point? Not really. The path of the ex food and energy deflator is quite distinctly down so underlying inflation (as defined by the Fed) is also declining. In Q1 2014 the ex food and energy deflator was+1.2%. In Q4 2014 it was +0.7%. Now it is +0.4%. This has nothing to do with food and energy. Something else is going on and rather casts doubt in the Fed’s inflation optimism. It is almost certainly in part a reflection of US Dollar strength but there is no reason this should not continue into the ‘medium term’. With so little inflation to be found in the world the Fed’s inflation optimism seems a touch daft.