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US Growth Strong and Steady But Inflation is Taking Off

Author: Roger M. Kubarych
April 29, 2004
Council on Foreign Relations


No one should be dismayed that the “advance” report of first quarter US GDP showed growth of “only” 4.2%, rather than the higher number that we and other analysts had anticipated. [This and all other GDP-related data are seasonally adjusted annual rates.]

Consumption, capital spending and the Military: Keys to US GDP growth

Percentage point contribution
to Real GDP Growth, saar

2004 Q1

2003 Q4

Real GDP growth



of which

Personal consumption



Private domestic Investment



of which

Business Investment, Equipment & Software



Business Structures



Residential construction






Net Exports






of which




State and Local investment



First, the sources of growth are reasonably well-balanced. Personal consumption expenditures accounted for just under two-thirds of total growth, about average. Business investment spending on equipment and software, which had shrunk during and after the recession, continued their robust recovery. They grew by an impressive 11.5% in the first quarter, down a only little from the nearly 15% increase in the prior period. That accounted for about a fifth of total growth, a better than average result. Admittedly, the overall growth outcome was pulled up by a resurgence of military outlays associated with Iraq and Afghanistan. To put it gently, it is a very different kind of economic activity than private capital formation. But all in all, this was a solid report.

Second, this highly preliminary growth estimate is likely to be revised upward when more information on investment, inventories and international trade becomes available. Business surveys are extremely upbeat. They suggest that final figures for March will lift the initial estimate of the growth rate.

Third, the past winter was harsh. The unusually nasty weather took a big toll on non-residential construction. Construction of business structures fell at an annual rate of 6.5% and in so doing subtracted 0.15 percentage point from growth, while a sharp decline in state and local government investment projects subtracted an even greater 0.33 percentage point. The weather is normal in the second quarter, so the chances of a bounce back are high.

The big problem is that relatively high growth was accompanied by a significant acceleration in the rate of inflation. That was unmistakable in the GDP numbers, as well as in other recent indicators of price pressures. The GDP price deflator increased at a seasonally adjusted annual rate of 2.5% in the first quarter. The deflator for personal consumption expenditures rose even faster, by 3.2%. That is far above the Federal Reserve’s last published internal forecast range for that measure of inflation. It brings the central bank that much closer to the point when they will begin the process of removing some of the extreme monetary accommodation that, along with powerful fiscal stimulus, has been a major factor behind the pick-up of US economic growth over the past year.

Progress report: The us economy compared with the Fed’s 2004 Economic projections

Forecast of 2/04

2004 Q1 saar

2004 Q4 over 2003 Q4

Real GDP growth



PCE chain-price deflator



To be sure, the 4.2% rate of growth lies toward the bottom of the Fed’s 4% to 5 ½% forecast range. But it hardly depicts economic weakness, certainly not in comparison to the performance of other major industrial countries. To the contrary, recent forecasts for the largest EU economy, Germany, have been trimmed to under 1% for 2004. The US should do four times better.

However, it may in fact be above the rate of growth that would tend to stabilize inflation over the medium-term. The Fed may simply have become too optimistic about the degree to which potential inflation dangers had been quelled.

The immediate market reaction to the report was a collective sigh of relief that it was not worse, and that it would not compel the Fed to tighten immediately. That much is probably true. But it didn’t take long for the markets to realize that the days of super-easy money are numbered.

That’s because the GDP figures were not the only important data released today. The all-important employment cost index was also released. This is the best measure of labor costs, because it combines wages and benefits. It rose 1.1%, not annualized in the first quarter. Wages are up only moderately (0.6% in the quarter, not annualized). But the cost of benefits, especially for employer-provided health insurance, literally exploded. Benefit costs were up 2.4% not annualized in the first quarter and up almost 7% from a year ago.

This report, and the sharp pick-up in the GDP price deflators, should not be comforting to either the bond market or the stock market. The bond market will progressively question the ability of the Fed to hold down inflation without a substantial increase in short-term interest rates. The stock market will look at the steep acceleration of labor compensation and ask whether continuation of high rates of growth of corporate earnings is feasible. Only foreign exchange markets seemed to enjoy the news, since the dollar often rises when the Federal Reserve raises interest rates. But for everyone else, the likelihood of a more volatile financial market environment in the months to come is high, rising, and a little nerve-wracking.

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