- While consumer prices continued to rise, the first quarter GDP report surprised investors with disappointing growth.
- This is the background to stagflation, which cannot be counteracted by interest rate cuts.
- The 1970s provide a warning of what happens when inflation gets out of control.
The last thing investors want to know is the latest GDP and inflation rates, which could signal serious problems down the road.
“This was the worst report for both countries. Growth was lower than expected and inflation was higher than expected,” said David Donabedian, chief investment officer at CIBC Private Wealth US.
Growth in the first quarter was much lower than expected, rising at an annual rate of 1.6%, according to the U.S. Bureau of Economic Analysis. This is not only well below expectations of 2.5%, but also short of the 3.4% growth achieved in the fourth quarter.
While such a weakening of the economy typically increases calls for interest rate easing to begin, the report also points to a larger-than-expected rise in consumer prices. This places significant limits on the Fed’s ability to act, as the central bank has made clear that inflation must fall before cutting rates. Stocks that had long priced in these layoffs plummeted.
This is also bad news for the economy. That’s because rapid growth and rising prices are the main drivers of stagflation, which is characterized by economic lethargy and persistently rising inflation. Such a scenario may be even more difficult to combat than a recession due to the dynamics outlined above. So the Fed’s hands are pretty much tied.
The last time America resisted stagflation was in the 1970s. This precedent provides a glimpse into how the U.S. economic situation may develop and explains why economists are trying to avoid a repeat.
Early in the decade, geopolitical disagreements led the OPEC coalition to restrict oil exports to the United States, and energy prices soared in response. Buoyed by massive government spending and the dollar’s decoupling from gold, inflation soared into double digits and the economy stagnated.
This era was so turbulent that long-standing macroeconomic theory broke down and the Fed needed to strengthen its role in the economy. Ultimately, to bring the situation under control, then-Fed Chairman Paul Volcker was forced to raise interest rates by a staggering 20%, and although the rise in prices subsided, the United States fell into a deep recession.
This is why today’s analysts shudder at comparisons with 50 years ago, and why forecasting stagflation is so important.
JPMorgan’s Jamie Dimon is among those who have recently warned that markets are becoming too optimistic about the state of the economy, alluding to the stagflation of the 1970s.
“I’m afraid it’s going to look more like the ’70s than anything I’ve ever seen,” a prominent bank president said at New York’s Economic Club last week.
His argument, which he has made many times, is that government spending will explode again while the economy is poised to take on a host of inflationary forces, from green industrialization to global rearmilitarization. It comes from the fact that
But stagflation is still a long way off. Even though inflation remains high, markets continue to price in at least one rate cut this year. Additionally, Barclays analysts led by Pooja Sriram noted after the GDP report that final sales to domestic buyers rose sufficiently to suggest “demand conditions remain strong.”
Friday’s personal consumption spending report, considered the Fed’s main inflation bellwether, will give investors a clearer picture of where inflation is heading. If interest rates rise further, the Fed will have little choice but to tighten policy further, Donabedian said.
“It won’t be long before all interest rate cuts are reversed as expected by investors, which will force Chairman Powell to adopt a more hawkish tone heading into next week’s FOMC meeting,” he said.