Why was real GDP negative in the first half of this year? Because inflation ate up all the gains.
The bombshell report this morning showed that real GDP shrank again in the second quarter, by 0.9% annualized, after a 1.6% drop in Q1. But wait, how can real GDP be shrinking while the labor market at the same time added 2.7 million jobs, and the unemployment rate fell from 4% to 3.6%? Because inflation ate up all the real economic gains.
Nominal GDP--actual dollars before any adjustment for inflation--surged by a whopping 6.6% in the first quarter, and 7.8% in the second quarter. That's twice the size of what we used to see in the sluggish expansion of the 2010s. Turns out, it's way more than this economy can actually handle. So the huge nominal GDP boom we've had is all simply going into higher prices; the inflation rate was over 8% in the quarter, and that's how you end up with a negative "real" print.
Was the U.S. actually in recession, meaning the end of a business cycle? Probably not, as we've already discussed. The economic indicators, from the labor market to retail sales to industrial production, were all higher in May than January, and so far for June as well. Just yesterday, new orders for durable goods--a key leading indicator--came in stronger than expected. Orders have steadily risen this year, running as of last month at a 6% annualized pace--which would not be happening at the end of a business cycle. As for leading gauges of the labor market, new jobless claims actually fell last week, to a modest 256,000.
What this all shows is an economy that was overheated by monetary and fiscal stimulus, not one that was too soft or too weak. How else do you end up with 8% surging nominal GDP last quarter, on top of last year's whopping 10% gain? Certainly you don't get that from supply-chain constraints or high oil prices. And because we couldn't handle it all quickly enough as "real" economic gains, instead we simply got higher prices. Inflation caused negative real GDP.
This causal relationship is extremely important. Why? Because most of the time when recession hits, people blame the Fed for running monetary policy too tightly. If they had loosened sooner, maybe the downturn could have been avoided, goes the thinking. But this time, the Fed ran policy too loosely, and the resulting inflation caused the negative real GDP prints. They were still injecting stimulus into the economy via their balance sheet as late as this spring!
Point being, anyone who reacts to these negative GDP prints suggesting that this is why the Fed should be cautious with rate hikes or tightening is getting the cause-and-effect backwards. These negative GDP prints show why the Fed should have tightened much more quickly, much earlier on. The biggest mistake now would be to back off of tightening and allow stagflation to persist for quarters or even years longer. The labor market is still churning out 4-6% wage inflation, making the odds of a rapid drop back to 2% inflation look slim.
What the first half of this year also demonstrates is the limit of stimulus in providing meaningful economic growth. We spent all of last cycle bemoaning that we had done "too little" after the financial crisis, and the Fed had to support the economy with stimulus all the way through 2014. There was even an intellectual opening for the "MMT" crowd to push for permanently larger fiscal stimulus as the basis for future economic growth.
That feels old-fashioned, now. We are seeing in real time the limits of stimulus in providing real growth. Worse, "it's hurting the bottom the most--the exact demographic it was meant to help," as John Spallanzani of Miller Value Partners said yesterday. "We just incinerated trillions, with very little to show for it," such as lasting infrastructure projects that could have been built with all that money instead.
Now Congress is going to take another stab at that, apparently, reviving parts of the president's "Build Back Better" plan as the "Inflation Reduction Act of 2022." Perhaps the $369 billion in proposed clean energy spending will have a more lasting positive effect, but it feels dicey with global energy security hanging in the balance. The other main components--capping Medicare drug prices, and raising taxes--have debatable impact.
Both the Fed and Congress at least now acknowledge that reducing inflation is the primary goal of the U.S. public. Less clear is whether they will actually follow through with it.
See you at 1 p.m!
Kelly