U.S. stocks and bonds were hit by inflation concerns over the past week, but what is the economic data telling us? A barrage of U.S. economic data was released over the past two weeks, including major reports such as fourth quarter gross domestic product (GDP), personal consumption expenditure (PCE) inflation, and the January employment situation report. We will discuss the impact of each individual report in more detail later, but overall the data deluge has signaled that the U.S. economy remains on stable footing. Signs of rising inflation were present in all three reports, which is one of the factors behind both stock and bond weakness over the past week. However, we would remind investors that, for now at least, inflation readings remain below the Federal Reserve’s (Fed) 2.0% target, and we would need to see continued acceleration before we would expect a more aggressive path of Fed rate hikes.
GDP Misses, But Underlying Data Shows Strong Demand
The advance release of fourth quarter GDP showed a year-over-year increase of 2.6% on an inflation-adjusted (real) basis. This was below the market’s expectation of 3.0%, and also below the 3.2% reading from the prior quarter. However, the underlying data was better than the headline portrayed.
An inventory drag, possibly hurricane related following rebuilding efforts late in the third quarter, was the major reason for the shortfall versus expectations. Trade also hurt, as import growth strongly outpaced export growth and widened the trade deficit. However, the report also featured strong demand, with consumer spending (+3.8%), business equipment investment (+11.4%), and residential construction (+11.6%) all seeing strong results. Government spending, which hasn’t been a major driver of GDP in recent years, also grew by 3.0% during the quarter, which is the best since 2015. Removing the impact of inventories and trade (a measure referred to as final sales, based on annualized data), growth would have come in at a solid 4.3%.
For the full year of 2017, GDP rose 2.3%, roughly in line with the expansion average, and we expect the impact of the new tax law may help push the pace up closer to 3.0% in 2018.
PCE Inflation Stable at 1.7%
Rising inflation expectations are one factor behind the recent rise in interest rates. Below-target inflation has been a persistent headache for the Fed in recent years, but market-based inflation expectations, such as 10-year breakeven inflation (based on the difference between the 10-year Treasury yield and 10-year Treasury Inflation-Protected Security [TIPS] yield) have started to increase in recent months. However, higher expectations have yet to translate into higher actual inflation, as shown in Figure 2.
This fact was again highlighted last week with the release of PCE data. Headline PCE met expectations at 1.7% year over year, but decelerated from its November reading of 1.8%. Core PCE (which excludes volatile food and energy prices, and is the Fed’s preferred measure of inflation), accelerated slightly from the previous month, but at 1.5% year over year remains well below the Fed’s 2.0% target. The report was broadly seen as a step in the right direction for the Fed, but a sustained upward move in inflation may be needed before the Fed can become significantly more aggressive.