The American economy rests on the knife’s edge as the trade and financial shocks changed corporate and consumer behavior in the first quarter of the year.
The result of these shocks was a 4.83% drag on the economy because of a widening trade deficit that was the primary cause of the 0.3% decline in gross domestic product on the quarter. On the year, the economy grew by 2%.
While final sales to domestic private purchasers, which is growth excluding inventories and trade, rose by 3% and final sales to domestic purchasers increased by 2.3%, these gains were a reflection of the economy’s health before the trade shock. Now, though, the economy is decelerating, and at an increasing rate.
A series of one-time increases in inventory building, equipment spending and what will be a more pronounced slowing in household spending will create sufficient headwinds in the current quarter to cause a more notable decline in the economy.
It is essential that investors, firm managers and policymakers understand that first quarter GDP was propped up by a $140 billion inventory build that boosted GDP by 2.25% while equipment orders similarly increased by 22%.
Together they bolstered first-quarter GDP by 3.1%. Neither of those will be repeated, though, creating a large drag in the current quarter.
While the economy did not tumble into a recession in the first quarter, unless there is a quick unwinding of the tariffs now hitting the economy, a recession will take place in midyear.
The problems inside the GDP report go beyond the one-time distortions that propped up growth in the first quarter of the year.
Now, inflation is starting to take hold, with the personal consumption expenditures price index, the Federal Reserve’s preferred measure of inflation, advancing to 3.7% and 3.5% excluding food and energy.
Given the large price shock that is coming and the likelihood of unemployment rising, it creates real problems for both the White House and the Federal Reserve.
Read more of RSM’s insights on the economy and the middle market.
The playbook at the Fed implies that when unemployment and inflation rise, the central bank will lean toward the side of their dual mandate—price stability and maximum sustainable employment—that is furthest from target.
With unemployment currently sitting at 4.2% (4.3% is full employment) and inflation at 3.7%, well above the Fed’s 2% target, that implies the central bank will not be cutting rates anytime soon.
Rather, the Fed will need to wait until the coming inflation surge is at or near a peak (I am not using the term transitory) or there are real cracks in the labor market.
One should expect further friction in the policy sector amid an economy that is navigating an air pocket, causing it to lose further elevation.
The data
Personal consumption advanced by 0.6% while durable goods spending declined by 3.6%. Nondurables demand increased by 2.7% and service spending increased by 2.4%.
Gross private investment jumped by 21.9% mostly because of that nonrepeatable 22.5% increase in equipment. Outlays on structures increased by 0.4% and intellectual property by 4.1%. Residential investment increased by 1.3%.
Exports increased by 1.8% while imports soared by 41.3%. Goods imports were up by 50.9% and service imports advanced by 8.6%. This is purely a function of tax avoidance by firms linked to the trade shock.
Government consumption declined by 1.4% with federal spending dropping by 5.1% and outlays on national defense declining by 1%. State and local spending increased by 0.8%.
In a separate report, the March income, spending and PCE price index report illustrated a 0.5% increase in personal income, compensation, wage and salaries, and disposable income. Personal income excluding transfers increased by 0.7% while the savings rate rose to 3.9% from 4.1%.
As trade taxes bite in the coming months, expect Americans to draw down those savings as personal disposable income turns negative.
Personal spending in March increased by 0.7% and advanced by 1.8% on a three-month average annualized pace, which matched the first-quarter GDP data.
Inflation was flat in the month and was up by 3.6% on a three-month annualized basis and 2.5% over the past six months. Excluding food and energy, inflation was also flat on the month and increased by 3.5% on a three-month average annualized basis and by 2.7% over the past six months.
Because of the coming price shock, the 2.3% top-line and 2.6% year-over-year increase in core inflation should be ignored because of the underlying trend over the past three and six months moving higher that will cause both the PCE price index and the Consumer Price Index to experience a reversal of past improvement.
The takeaway
The American economy is currently navigating an air-pocket that has caused it to rapidly lose altitude. It has entered a period that is best characterized as stagflation and that will in the near term limit the degrees of freedom on policy at the Federal Reserve.
The economy rests on the knife’s edge of a recession with the decision between an economic downturn and a grinding to minimal growth residing at 1600 Pennsylvania Avenue on just how far to push tariffs.
If the punitive tariffs that are scheduled to begin on July 9 are not implemented—and there have been signs of easing in recent weeks—then a recession might be avoided.
