However, if first quarter real GDP growth is essentially zero, this will have occurred in a quarter where payroll employment rose by 4.8%. This implies a significant drop in productivity and we now estimate that productivity in the non-farm business sector rose by just 1.4% annualized over the past two and a quarter years—only a modest improvement from the prior decade.
We expect that both economic growth and productivity growth will pick up in the second quarter. Still, first-quarter weakness suggests that economic rebound from the pandemic is losing momentum.
While the Federal Reserve will not be unhappy to see some slowdown in an overheating economy, they are clearly impatient for some better news on inflation.
Friday’s report on consumer income and spending will contain the government’s latest read on inflation as measured by the personal consumption deflators. We expect the March headline consumption deflator to log a 6.8% year-over-year gain, its strongest increase in over 40 years.
That being said, it looks likely this will mark a peak in the inflation cycle. Oil prices, although still running above $100/barrel, are down from their March average while food commodity prices are roughly unchanged from very high March levels. Used car prices have fallen slightly in recent months and light-vehicle production, while still down from pre-pandemic levels, climbed to its strongest level in over a year in March, helping alleviate chronically low inventories. Most of the rebound in airline fares also now appears to be behind us.
However, because of fast-growing wages and rents and elevated inflation expectations, we expect inflation to only back off slowly. By the fourth quarter of this year, we expect the headline consumption deflator to be up 5.0% year-over-year and the core consumption deflator to be up 3.7% - both still well above the Fed’s 2% target.
The Federal Reserve seems very well aware of this and the last week saw a number of Fed officials make hawkish comments about the need for a swift increase in short-term interest rates. Based on these comments, it now appears likely that the Fed will increase the federal funds rate by 50 basis points at their May and June meetings and that they will formally announce a plan to reduce their balance sheet at their May meeting.
Futures markets have fully priced in this hawkish tilt, with contracts now implying four 50 basis point rate hikes in May, June, July and September followed by two 25 basis point hikes in November and December, taking the funds rate to a range of 2.75%-3.00% by January 2023. One Fed official has even argued for a more aggressive stance, pushing the funds rate to 3.5% by the end of this year.
However, such aggressive action would likely be a mistake.
Slowing economic growth and a resolution of some supply chain issues should cause the inflation rate to moderate over the rest of the year and in 2023. Moreover, because there is such a financial incentive to fix supply changes and replenish inventories, it is quite possible that within a few years, supply chains will have surplus capacity and that shelves will be over-stocked, exerting deflationary forces on the economy.