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Growth Data (Seem To) Take A Softer Tone

May 2024

The initial estimate from the Bureau of Economic Analysis (BEA) showed real GDP growth of 1.6 percent in Q1, well below expectations of growth closer to 3.0 percent. At the same time, the price data in the GDP report showed the core PCE Deflator, the gauge of inflation followed most closely by the FOMC, rose at an annualized rate of 3.7 percent in Q1. Suffice it to say that the day on which the report on Q1 GDP was released was not a particularly good day in the markets, with equity prices down sharply and yields on fixed-income securities shooting higher. The growth details of the report were seen as negative for equities, while the inflation details fed into the narrative that the FOMC would be on hold for longer, perhaps much longer, than many market participants had previously anticipated. On the whole, the report on Q1 GDP triggered fears that the U.S. economy was doomed to a period of stagflation, i.e., stagnant growth and high inflation.

It will come as no surprise to our regular readers that our reaction to the report on Q1 GDP was, let’s say, a bit more tempered. It is often the case that inventories and trade, the two most inherently volatile components of GDP, team up to impact GDP growth in a manner at odds with underlying economic conditions, which we believe to be the case with the Q1 data. A slower pace of inventory accumulation in the nonfarm business sector and a sharply wider trade deficit combined to knock 1.2 percentage points off Q1 real GDP growth. In contrast, real private domestic demand, or, combined household and business spending adjusted for inflation, grew at an annual rate of 3.1 percent in Q1, a third straight quarter of growth at or above 3.0 percent.

Nonfarm business inventories increased in Q1, but that they did so at a slower pace than in Q4 2023 acted as a drag on Q1 real GDP growth. It is, however, difficult to draw any firm conclusions as to what the pace of inventory accumulation says about the broader economy given that the severe distortions to both production and sales wrought by the pandemic and the policy response to it have yet to fully resolve. Under GDP accounting conventions, a wider trade deficit acts as a deduction from real GDP growth. What is almost always overlooked, however, is that in any given quarter roughly one-half of all goods imported into the U.S. are either raw materials, intermediate goods, or capital goods used by firms in the U.S. to produce final goods and, as such, are supportive of future growth. The GDP math notwithstanding, it’s hard to make a plausible case that this is a negative for the U.S. economy.

May 2024 chart

We always, for better or worse, place far more emphasis on patterns in real private domestic demand than on patterns in real GDP to help us assess the state of the economy. As such, we’d be much more concerned about the state of the economy had the miss on Q1 real GDP growth been caused by shortfalls in the business and residential fixed investment components of private domestic demand, each of which was a bit stronger in Q1 than we expected. That said, the GDP data are backward looking given that they come with a lag, and thus far the initial data releases for the month of April have been on the soft side.

For instance, the Institute for Supply Management’s (ISM) Manufacturing Index and Non-Manufacturing Index each slipped below the 50.0 percent breakeven line between contraction and expansion in April. As we often point out, however, the manner in which the ISM’s diffusion indexes are calculated can lead to the headline index being out of alignment with the firm-level and industry-level details of the data. We believe this to be the case with the April data. The ISM’s surveys query firms on whether metrics such as output, employment, and new orders increased, decreased, or stayed the same compared to the prior month. Aside from seismic events, say, a global financial crisis or a global pandemic, clear majorities of firms report no change in these metrics from one month to the next. So, just as life happens on the margins (economist humor!), so too do the changes in the ISM’s diffusion indexes. For instance, in the April survey of the manufacturing sector, sixty-three percent of firms reported no change in orders from March, and while more of the remaining firms said orders rose than said orders fell, that gap was smaller than was the case in March, yielding a decline in the new order index that, in turn, weighed on the headline index.

We go into this detail here not only to help explain how we routinely process the economic data but to also illustrate a point we often make, which is that for any given data release, the details are more important than the headline numbers. The April employment report is another illustration of that point. Total nonfarm payrolls rose by 175,000 jobs in April, well short of expectations. Additionally, average hourly earnings rose by just 0.2 percent, yielding a year-on-year increase of 3.9 percent, the smallest such increase since June 2021, while the unemployment rate rose to 3.9 percent. The April employment report was roundly cheered by market participants, as the appearance of softening labor market conditions inspired hope that the FOMC would be free to start cutting the Fed funds rate this year after all, in stark contrast to the mood in the markets in the wake of the Q1 GDP report.

In keeping with our theme here, appearances can be, and often are, deceiving. While we’ve for months pointed to signs of a cooling labor market, we think the April employment report meaningfully overstates the degree to which that is the case. The main culprit, at least in our view, is the calendar. Specifically, the survey period for the Bureau of Labor Statistics’ (BLS) April establishment survey ended prior to the middle of the month, which historically has held down response rates to the establishment survey and biased estimates of nonfarm employment, hours, and earnings lower. The initial response rate to the April establishment survey was the third lowest since the onset of the pandemic, and the increase in nonfarm employment shown in the not seasonally adjusted data was much smaller than the typical April increase, meaning the estimate of seasonally adjusted job growth was biased lower. That, in turn, flowed through to estimates of hours worked and average hourly earnings.

So, while the headlines on the data releases for the month of April seen to date suggest a marked slowing in the pace of economic activity, the details of the various releases don’t necessarily back that up. Time will tell whether our take is way off base or on the mark. But, even if the pace of growth is slowing, the FOMC won’t be moved, nor will the Fed funds rate, unless and until the inflation data tell the same story. Circling back to the ISM’s April surveys, in both the manufacturing and services sector there was further evidence of broadly based upward pressure on prices for non-labor inputs, which in and of itself is at odds with the narrative of slowing growth, let alone contraction.

While we think a large part of the market’s dismay over the price data in the report on Q1 GDP is the manner in which the data are presented, i.e., annualized rates of change from the prior quarter which, in the case of the core PCE Deflator, we think overstates the case. To be sure, the monthly data show progress in pushing inflation lower has stalled, and the year-on-year increase of 2.8 percent in Q1 is too high for the FOMC’s comfort. In that sense, while the markets’ collective hopes seem to rise and fall with each individual data release, we don’t think the data for the month of April seen thus far have changed the thinking within the FOMC one bit, leaving the Committee a long way from seriously considering Fed funds rate cuts.

Sources: Bureau of Economic Analysis; Bureau of Labor Statistics; Institute for Supply Management

As of May 9, 2024

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