Weak GDP is first stress test for inflation fighters

I have been saying for a while that inflation expectations will remain high until policymakers prove they can restrain their stimulus spending during an economic slowdown. Today’s weak GDP report could be that first sign. The stress test begins now.

First-quarter GDP growth slowed to 1.6 percent, down from 3.4 percent in the fourth quarter of 2023, and 4.9 percent the quarter before that. Growth is now lower than the century-long running average of about 2 percent. While the economy is still growing and not in recession, this is not good news.

The Fed has already done almost everything it can to fight inflation in terms of monetary policy, though keep in mind the Fed’s panicked response to COVID-19 largely caused today’s high inflation in the first place. For the last two years the Fed has kept money supply growth in check, and interest rates are now roughly where they should be.

The reason inflation is still high is because of the public’s inflation expectations. Markets think politicians will go into stimulus mode whenever the economy cools off, and they are factoring that into their pricing decisions going forward. Stimulus causes inflation, and most people expect some of both whenever the economy hits a rough patch.

This story is not new. The 15 years of high inflation in the 1960s and 1970s were basically this same expectations story playing on a loop, until Paul Volcker gave the Fed credibility by sticking to his guns on high interest rates, even during a severe recession. After that, markets believed he was serious about fighting inflation, and those last couple of percentage points of inflation went away.

Today’s GDP news might be an inflection point in the latest iteration of that expectations story.

The Federal Reserve’s Open Market Committee meets next week. Will it hold interest rates steady and signal it is serious about inflation? Or will it cut rates to stimulate a possibly slowing economy? Keep in mind that stimulus now would come at the tradeoff of higher inflation and slower growth later, and markets know this.

The Fed is not the only actor in this story. Will Congress and President Biden hold off on another big spending bill? Or will they give in to stimulus temptations during an election year? If they decide to stimulate, the Fed is more or less obligated to help finance it, even if it doesn’t want to.

It is possible today’s 1.6 percent GDP release is just a blip, though this is the second straight quarter of slower growth. One piece of good news is that the labor market still appears to be in good shape. Today’s initial jobless claims number came out at 207,000 people. The break-even point is around 400,000, so the labor force is likely still growing.

We’ll find out more in the weeks to come, but the fact that neither party has fiscal credibility is not a good omen – for inflation expectations or sound monetary policy.