Slow growth, sticky prices: a whiff of stagflation

US GDP grew at an annualized 1.6 per cent in the first quarter, well below forecasts, while the core PCE price index rose at an annualized 3.7 per cent. Slower growth and firmer inflation in the same release brought back unwelcome memories of 1970s stagflation. It is the combination central bankers like least.

From soft landing to stall

The disappointment was sharper because of what came before. The economy grew at a 3.4 per cent annualized rate in the final quarter of 2023, and core PCE inflation had run at 2.0 per cent over the same period, which looked like a textbook soft landing. The Fed's own projections in December and March pencilled in three rate cuts this year on the strength of that picture.

The first quarter reversed both halves of it at once. Growth roughly halved from the pace of late 2023, and the inflation measure the Fed targets more than doubled its quarterly rate. The monthly figure for March, released a day after the GDP report, left core PCE inflation at 2.8 per cent from a year earlier, barely lower than at the turn of the year.

Damned either way

The mix leaves the Federal Reserve in an awkward spot. Cutting rates to support a slowing economy risks entrenching core inflation. Raising them to squeeze out sticky prices risks pushing that same economy into recession. When growth slows and inflation picks up at the same time, a central bank has very little room to move.

The policy rate is already at 5.25 to 5.50 per cent, where it has been since July, and the Fed meets again on 30 April and 1 May. Wage data add to the discomfort. The employment cost index, published on 30 April, rose 1.2 per cent in the first quarter, faster than expected, which weakens the argument that the labour market is cooling on its own.

Markets moved quickly to the more hawkish reading. The ten-year Treasury yield rose towards 4.7 per cent after the GDP release, and futures pushed the first expected cut further into the second half of the year. The committee is also expected to discuss slowing the pace at which it shrinks its balance sheet, a technical step aimed at money-market plumbing that investors would be unwise to read as a signal of easier policy.

Looking inside the 1.6

The headline growth number flatters the gloom. Most of the shortfall came from two volatile items: a smaller build-up of business inventories and a jump in imports, which subtracts from GDP in the national accounts. Final sales to private domestic purchasers, a measure that strips out trade, inventories and government, grew at 3.1 per cent. That is a solid pace, and it points to demand that is still running hot rather than fading.

This matters for the diagnosis. Stagflation in its classic form means weak demand and rising prices, usually after a supply shock. The first-quarter data look more like firm demand meeting an economy that is importing more and restocking less. If that reading is right, the Fed's problem is an economy that refuses to cool, and the case for cutting rates is weaker than the headline growth figure implies.

How far from the 1970s

The historical comparison also has limits. In the 1970s, oil shocks in 1973 and 1979 drove inflation into double digits, unemployment rose well above current levels, and expectations of future inflation came loose. It took Paul Volcker's Fed pushing the federal funds rate to about 20 per cent, and two recessions, to break the cycle. Today unemployment is 3.8 per cent, energy prices are not surging, and longer-term inflation expectations in surveys and bond markets have stayed broadly steady.

The lesson the Fed takes from that decade is less about the numbers than about sequencing. Policymakers in the 1970s eased repeatedly at the first sign of slower growth, before inflation was beaten, and each time prices came back harder. Powell has referred to that history more than once. It is the main reason the committee would rather hold too long than cut too early.

Who pays for the wait

A long hold falls hardest on borrowers who need to refinance. Small companies with floating-rate bank loans, commercial property owners facing maturities and households carrying credit-card balances all pay rates tied directly to the Fed's benchmark. Savers in money-market funds and short-dated Treasuries keep earning more than five per cent. The dollar tends to benefit too, because rate cuts elsewhere are likely to arrive sooner.

Other central banks face a different mix. The European Central Bank has all but promised a first cut in June, with euro-area growth close to stagnation and inflation falling faster than in America. A Fed on hold while others ease tends to lift the dollar, which tightens conditions for emerging-market borrowers with dollar debts while exporting a little disinflation back to the United States through cheaper imports.

What would settle it

The case against this column is that one quarter of GDP is noisy and heavily revised, and the second estimate in late May may look different. That is fair. What would change the call is the monthly data: a run of softer core inflation readings in the April and May CPI reports, or a clear slowdown in payrolls and consumer spending. Either would give the Fed room to start cutting later in the year. Neither is yet in evidence.

The opposite risk also deserves a hearing. If the underlying demand revealed by the private final sales figure persists, and core inflation keeps running near four per cent on a quarterly basis, the conversation inside the Fed could shift from when to cut to whether the current rate is restrictive enough. Powell has so far played down the idea of another increase. A few more months of data like the first quarter's would make that position harder to hold.

One quarter does not make a 1970s rerun, but the Fed now faces a harder choice than it did at the start of the year. Rates will probably stay on hold for months while policymakers wait to see which problem grows faster, and a first cut before the autumn now looks unlikely.