Real GDP slowed to a 2.1% pace in the second quarter on the heels of strong gains in consumer and government spending. Some of that reflected a rebound from a weak first quarter when the polar vortex, trade wars and higher short-term rates took a toll on consumers; the government shutdown at the start of the year delayed federal spending in the first quarter.
The performance of business investment and trade was more worrisome in the second quarter. Business investment essentially flatlined in response to weakness abroad and escalating trade tensions, while exports actually dropped. The hike in tariffs for intermediate goods from 10% to 25% is disrupting global supply chains and making it more expensive to export as well as import. Components often cross borders several times before they become a final product.
The administration is now levying tariffs on Vietnam, Thailand and South Korea to punish them for helping producers avoid tariffs on goods produced in China. This is at the same time that trade tensions within Asia have intensified. Japan has stopped shipments of materials critical to South Korea’s tech sector on national security grounds. The real dispute is diplomatic: South Korea wants Japan to apologize for atrocities committed when it occupied Korea. This conflict underscores how contagious tactics on the trade front can be.
One silver lining in the second quarter GDP report was the sharp drop in inventories, which had ballooned in recent quarters. The rebound in consumer spending helped reduce those inventories, which should help producers tied to domestic production over the summer.
The report showed a pickup in the Personal Consumption Expenditures (PCE) core index, the Federal Reserve’s favored measure of inflation. It is still below the Fed’s target of 2.0%, which is one of the justifications the Fed will use for a rate cut at the end of July.
It is important to note that we are where we expected to be when we assumed that the Fed would be raising instead of cutting rates. We needed the Fed to do a U-turn to stabilize financial markets and keep the economy moving forward. The Federal Open Market Committee (FOMC) realizes this and will deliver on a rate cut to keep the economy moving forward.
Separately, revisions to GDP for the last five years showed a downward revision for last year. The fourth quarter to fourth quarter measure of GDP growth, which better measures momentum than an annualized rate, came in a full one-half percent lower than previously estimated. That suggests the tax cut had an even smaller impact on growth than initially estimated.
There is a dissonance in today’s GDP report. Consumers spent with abandon while businesses did not. Something has to give. Either businesses need to come back and support both hiring and investment, or consumers will pull back. That is not where one would expect us to be so late in an expansion. In the late 1990s, consumers and businesses were both spending with abandon.
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