By John Beuerlein, chief economist, Pohlad Companies
The initial reading for 1Q-18 GDP is 2.3 percent, down from the 4Q-17 reading of 2.9 percent. This was somewhat expected as first-quarter GDP has exhibited weakness in five of the last six years. On a year-over-year basis, however, the economy is growing at a healthy 2.9 percent rate.
The underlying details of the 1Q-18 report were not strong. Specifically, personal consumption, the primary driver of this economy, grew at a 1.1 percent annualized rate – down from the 4.0 percent rate recorded in 4Q-17. This weakness was not surprising given that consumers had drawn down their savings to the lowest level in decade at the end of 2017. The critical determinant of GDP growth in 2Q-18 will be the extent to which consumer spending rebounds. The added take-home pay that consumers have as a result of the Tax Cut & Jobs Act should help spending rebound.
The April employment report indicated that the average hourly earnings of all employees grew at a 2.6 percent year-over-year rate for the third month in a row. If we couple this information with the year-over-year growth of unit labor costs (1.1 percent through 1Q-18), it appears that wage pressures are still sufficiently moderate to prevent Fed officials from worrying that they are at risk of falling behind the inflation curve.
Most measures of inflation are continuing to advance at a slow and steady rate, which will allow the Fed to maintain its stated path of rate increases. The futures market projection for the Fed Funds rate over the remainder of 2018 is consistent with Fed expectations. Both are expecting two additional interest rate hikes this year.
More importantly, the yield curve continues to flatten. The difference between 10-year Treasury yields and 2-year Treasury yields is now down to 42 basis points. The flattening of the yield curve shows that the Fed’s tightening policy is effective and liquidity is being drained from credit and money markets. Corroborating this observation is the fact that money supply growth has been slowing, which typically leads to tightening liquidity in credit markets.
If short rates (2-year Treasury yields) continue to advance and move above the 10-year Treasury yields, we have a situation known as an inverted yield curve. This is a condition that has preceded every economic slowdown over the last 60 years. While this condition is not of immediate concern, it warrants ongoing monitoring.
Although the U.S. economic landscape is holding firm, there are signs developing that a transition to slower growth may be developing as we move through 2018 and lose the positive impact of the Tax Cut & Jobs Act passed last December. Rising yields, a flattening yield curve, slowing money supply growth, and increased market volatility all suggest that credit market cycle is in its later stages and the economic cycle is maturing.