The economy barely got out of its way during the early part of the year. Economic growth was less than 1%, which is modest even by this mediocre recovery’s standards. But there were other factors that indicate business activity is not weakening. Still, it looks like another year of less than stellar economic growth.
The details of the GDP report were mixed, which is surprising given the soft economy. Household spending slowed, especially on big-ticket items. After purchasing every motor vehicle that moved for two years, some easing was not a surprise. Yet families purchased homes fostering strong residential construction.
Meanwhile, businesses decided that with tax cuts potentially coming, it was a good time to invest. Firms spent heavily on equipment, buildings, software and computers. But just in case the household consumption slowdown continued, firms made sure they wouldn’t be caught with a lot of goods they couldn’t sell by reducing inventories sharply. That was the major reason growth was so slow.
If you just considered private domestic consumption and investment, the economy expanded by more than 2%.
But even the modest expansion came with a price as the labor markets tightened further. Job gains were solid, causing the unemployment rate, no matter how it is measured, to drop to its lowest level since 2007.
Normally, a lack of slack in the labor markets would be considered to be good news. It is, as long as it doesn’t create major problems for businesses. However, wage gains are accelerating. The increases have not risen to the point where businesses are being forced to raise prices significantly, but that could be coming.
The building pressure on business costs makes it unclear how much longer inflation can remain at its current moderate pace. Already, it has reached the Fed’s target rate of 2%. Can it go higher? Absolutely, for two major reasons: Productivity is not strong and input costs are rising.
During the last decade, firms offset upturns in their costs by operating more efficiently. That has not been happening. The combination of weak productivity, rising wages, and increases in imported goods and producer costs is setting the stage for even higher inflation in the months ahead.
The prospect that consumer costs could accelerate is worrisome. The Federal Reserve has made it clear it wants to normalize rates. Although the economy may not grow rapidly over the next year, it should expand enough to speed up the wage and goods inflation we already are seeing. The Fed will make sure inflation doesn’t get too high by raising rates.
Looking forward, the economy should expand this year at a pace similar to what we have seen over the past five years – about 2¼%. With tax cuts and spending increases not expected to pass Congress before the year’s end, the hoped-for fiscal stimulus is almost a year away. Nevertheless, expect the unemployment rate to fall, wages to rise faster, and inflation to accelerate. That means the Fed is likely to raise rates at least twice more this year.