The slowing growth and stubborn inflation picture emerging in the U.S. economy may not be quite a nightmare scenario for the Federal Reserve, but it at least could make for some restless sleep. First-quarter results released Thursday showed the U.S. economy slugging along at a 1.6% annualized pace, the slowest in almost two years, and inflation running nearly double where it was in the previous quarter and at the highest level in a year. The two data points put together spell at least a mild stagflationary environment that will make policymaking troublesome in the weeks and months ahead. “It was obviously not expected. I think maybe it was overdue,” Matthew Ryan, head of market strategy at global financial services firm Ebury, said of the Commerce Department’s GDP report . “We have seen a U.S. economy that has not only defied expectations, but I would say defied conventional logic in recent months and grown at a very solid pace that you would think is probably not attainable this deep and this long after the Federal Reserve starting hiking interest rates.” Markets had been looking for the string of good readings dating back to mid-2022 to continue, with economists estimating real GDP growth of 2.4% and inflation readings around 3%. What it got was essentially what some on Wall Street called the worst of both worlds, with weakening growth and stubborn price pressures. As a result, stocks sold off sharply , Treasury yields bounced higher, and futures traders — again — had to reprice their expectations for Fed rates. After starting the year expecting at least six reductions, the market is now down to one, with another implied cut taken off the table, according to the CME Group’s widely followed FedWatch tracker that imputes probabilities based on fed funds futures contracts. While there might be some logic in thinking the Fed might view a slowing economy as conducive to easing policy, Ryan said officials will likely more closely examine the personal consumption expenditures price index data, their preferred inflation gauge. During the first quarter, headline PCE rose at an annualized pace of 3.4% for the all-items measure and 3.7% for the core that excludes food and energy costs. The Fed will get a more granular look at PCE data on Friday when the Commerce Department releases the monthly figures for March. “I don’t think that the Fed will be swayed too much with a slightly weaker than expected GDP number, and even the 1.6% annualized data is not an absolute disaster. It’s still a fairly solid growth number,” Ryan said. “The Fed will be far more concerned with seeing inflation.” Indeed, some Wall Street commentary noted that the GDP number is no cause for concern. Weakness came primarily from inventory and federal government spending, while growth “is picking up in those sectors that reflect improved confidence in the economy moving forward,” wrote Steven Blitz, chief U.S. economist at TS Lombard. “The math does not add up to a weak private sector.” Blitz did note the problem of a strong dollar moving capital equipment purchases to foreign producers, and the data reflected a subtraction to GDP because of rising net imports. “What does the Fed do against all this? Stand still for now, as the probability of any cuts this year continues to ebb away,” he said. “But, in the end, this is a real growth story, a good thing.” Citigroup, one of the few firms left on the Street that still expects a dovish Fed this year, stuck to its call Thursday, saying that Fed officials likely will be inclined to head off diminishing growth with rate cuts and will be encouraged to do so by waning inflation indicators ahead. “Softer growth concerns will be a key factor in Fed considerations to cut, and Q1 GDP details show fading support from fiscal stimulus and softer goods spending,” wrote Citi economist Veronica Clark. “We still think Fed cuts are coming this summer, before inflation has sustainably slowed.”
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