- Q1 GDP growth was better than expected, but the underlying components were less favorable
- Disinflation concerns have been voiced by some Fed leaders, leading the market to price a higher probability of a 2019 rate cut
- Fed Chair Powell did not share those concerns following the May 1 FOMC meeting, describing recent inflation trends as “transitory”
The initial reading of Q1 GDP growth was better than expected at 3.2%, but the underlying components were less favorable. More than half of the topline growth figure was attributable to inventories and trade, and personal consumption and business investment readings were less robust. Real domestic final sales, which excludes the inventory effect and government spending, rose at just a 1.3% annualized rate, the weakest since 2013. Inventories rose despite a big drop in imports, which is another reflection of soft personal consumption. While business investment was relatively weak in Q1 as a whole, March data were more constructive for Q2 momentum.
A greater theme emerging from the Q1 GDP report from a market perspective were tepid inflation readings, and the March PCE data released a few days later confirmed a decline in year-over-year core inflation to 1.6%. This has sparked greater speculation that some Fed leaders may push for an “insurance” rate cut soon to combat disinflation risks. Chicago Fed President Charles Evans, a noted dove, recently expressed concern regarding core inflation staying near 1.5% for several months. “I would be extremely nervous about that, and I would definitely be thinking about taking out insurance in that regard,” said Evans. The fixed income market is now pricing a full 25 basis points (bps) rate cut by the end of this year.
The Federal Open Market Committee (FOMC) chose not to change the fed funds target range at the May 1 meeting, although it did initiate another 5 bps technical adjustment to the interest on excess reserves (IOER) rate. The IOER is now set at 2.35%, 15 bps below the top end of the target range. The cut to IOER was somewhat expected, and Powell downplayed the decision as a “small technical adjustment.” The official statement acknowledged the slowing of personal and business consumption in Q1, and it also noted that “inflation for items other than food and energy have declined and are running below 2%.”
At the press conference, Fed Chair Powell was more dismissive of the disinflation concerns expressed by some of his colleagues. Said Powell, “Let me say, I don’t mean to diminish concerns about too low inflation. But I think there’s good reason to think that these readings are particularly increased by some transitory factors.” In other words, Powell is hesitant to be overly reactive to periodic data swings, and he also said that he doesn’t see a strong case to move rates in either direction at the present time. Fed leadership is content to leave rate policy unchanged for the foreseeable future until the growth and inflation trend changes significantly.
Adjustments to IOER have a greater impact on funding markets, to a degree, but that hasn’t really materialized just yet. Treasury bill yields had already fallen in anticipation of the IOER cut, but as of May 2, funding/repo markets haven’t repriced lower. The latter is likely attributable to month-end factors.
Recent reports suggest that U.S./China talks continue to progress. A U.S. delegation was in China earlier this week, and Chinese officials have been more willing to concede to U.S. demands according to sources close to the negotiations. President Xi of China could travel to the U.S. in the next month to finalize the deal, but at the same time, such a trip has been rumored since early March to no avail. Equity markets have been pricing for a positive solution on the matter for some time, and the bigger wildcard has been the global data trend, particularly in the manufacturing sector. However, there have been some signs that global manufacturing may be poised for a rebound, which would be well received by global markets. At the same time, a rally in the U.S. dollar for much of April boosted commodity prices and weighed on emerging markets, but the dollar has relented over the last week following the release of more tepid U.S. inflation readings.
The financial markets continue to wrestle with the direction of growth, inflation, and monetary policy. Global data appear to be improving and U.S. data remain solid, but inflation, both domestic and abroad, remains stubbornly tepid. One potential headwind that has been looming for a while now is the growing U.S. budget deficit. At some point, one would expect this to weigh on bond markets, but it has not been a major concern yet. However, if major fiscal spending initiatives (infrastructure, healthcare, green deal, etc.) gain political momentum, market attention could quickly shift to deficit concerns.
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