Fed Watch: GDP, Inflation Prompt Stagflation Worries, Pressuring Central Banks

Economists are facing an array of conflicting data. That gives each of them an opportunity to be partly right—inflation is surging, but maybe has peaked, interest rate increases will dampen demand, but real incomes are already shrinking, and so on.

But the bottom line is the GDP measure of US economic growth showed a decline of 1.4% in the first quarter, and the personal consumption expenditure index of inflation for March surged 6.6% on the year.

The GDP figure may be revised upwards and the PCE inflation figure includes those volatile food and energy price increases Federal Reserve policymakers prefer to ignore; (“core” PCE gained 5.2% without those pesky things people have to buy). But on the face of it, those two data points point to stagflation—low or negative growth combined with high inflation.

It’s not really possible to talk your way out of it, no matter how many equivocations you inject into a fundamental analysis (and financial analysts are full of such equivocations).

Now the same bank economists who expected 1.1% growth in the first quarter are saying not to worry because underlying demand remains strong and the second quarter will show a rebound. The analysts at Dutch bank ING last week wrote:

"Looking to 2Q, we are confident the growth number will be better despite fiscal and monetary policy becoming less supportive. While inflation is hurting spending power, nominal incomes are rising strongly and there are decent employment gains that in combination can keep spending firm."

This is equivocation 101. At the same time, economists are confidently forecasting the Fed will raise interest rates by half a point at both its May policy meeting this week and the June 14-15 meeting. This kind of “aggressive” action is designed to dampen demand. ING seems to want to have its cake and eat it, too.

ECB Behind The Inflation Curve; US Recession Looms

If stagflation sounds bad, recession sounds even worse, and stock markets tanked on Friday as investors started battening down the hatches. Technically, recession occurs with two successive quarters of GDP decline, so we’re already halfway there.

Deutsche Bank economists are more pessimistic than those at ING. After being the first big bank to forecast a recession in April, the German bank, with significant Wall Street business, is now doubling down and projecting a “major recession” in the US, not the mild one it had been expecting.

The Deutsche economists point to history and the fact that the Fed is further behind the curve on inflation than it was even in the 1980s and has “never been able to correct” even weaker inflation without a significant recession. Inflation, they conclude, is not going away anytime soon.

Meanwhile, the European Central Bank is apologizing for getting its inflation forecasts so wrong. Inflation hit 7.5% in April, its sixth consecutive increase and a record high for the eurozone, and is putting pressure on the central bank to finally start doing something about it.

Gee whiz, the ECB experts said, our models missed forecasting the sharp rise in energy prices, the disruption of supply-chain bottlenecks, and rapidly rebounding demand in the wake of the pandemic.

After ECB officials, led by President Christine Lagarde, but also including chief economist Philip Lane, pooh-poohed the need for higher rates until very recently, analysts now expect the central bank to start raising rates in July and to hike twice more before year-end.

Two countries that remained outside the eurozone, Britain and Sweden, aren’t waiting for the ECB to act. The Bank of England is expected this week to keep with its mini-hikes of 0.25 percentage points and raise its benchmark rate for the fourth consecutive policy meeting, to 1%.

Sweden’s central bank last week bid farewell to zero interest rates, raising its policy rate to 0.25%, the first time above zero since 2014. The Riksbank said it is ready to raise rates two or three times more this year if necessary to fight inflation.